Global Political Economy: Understanding the International Economic Order

Global Political Economy UNDERSTANDING THE INTERNATIONAL ECONOMIC ORDER Robert Gilpin W I T H T H E A S S I S T A N C E O F Jean M Gilpin P R I N C E T O N U N I V E R S I T Y P R E S S P R I N C E T O N A N D O X F O R D Copyright 2001 by Princeton University Press Published by Princeton University Press 41 William Street Princeton New Jersey 08540 In the United Kingdom Princeton University Press 3 Market Place Woodstock Oxfordshire OX20 1SY All Rights Reserved Library of Congress CataloginginPublication Data Gilpin Robert Global political economy understanding the international economic order Robert Gilpin with the assistance of Jean M Gilpin p cm Includes bibliographical references and index ISBN 0691086761 alk paper ISBN 069108677X pbk 1 International economic relations 2 Free trade 3 International finance 4 Technological innovationsEconomic aspects 5 Economic development I Gilpin Jean M II Title HF1359 G5516 2001 337dc21 00051684 This book has been composed in Sabon The paper used in this publication meets the minimum requirements of ANSINISO Z39481992 R 1997 Permanence of Paper wwwpupprincetonedu Printed in the United States of America by Princeton University Press Princeton Oxford 10 9 8 7 6 5 4 3 2 1 10 9 8 7 6 5 4 3 2 1 Pbk Contents List of Abbreviations and Acronyms ix Preface xi ONE The New Global Economic Order 3 Changes in the World Economy 5 Intellectual Perspectives 13 My Perspective Statecentric Realism 15 Purpose of Economic Activity 23 Conclusion 24 TWO The Nature of Political Economy 25 What You Seek Is What You Find 31 The Nature of an Economy 38 Embeddedness of the Economy 41 Conclusion 45 THREE The Neoclassical Conception of the Economy 46 The Discipline of Neoclassical Economics 46 Nature of a Market 54 Method of Comparative Statics 57 Intellectual Limitations 60 Economists and Public Policy 69 Comparison of Economics and Political Economy 74 Conclusion 76 FOUR The Study of International Political Economy 77 Distribution of Wealth and Economic Activities 78 National Autonomy 80 The Politics of International Regimes 82 Theory of Hegemonic Stability 93 Governance of the Global Economy 97 Conclusion 102 FIVE New Economic Theories 103 Change and Neoclassical Economics 104 World View of the New Theories 106 v C O N T E N T S The New Theories 108 Conclusion 127 SIX The Political Significance of the New Economic Theories 129 National Governments and Domestic Economies 129 Oligopoly and Power in Economic Outcomes 132 Technological Innovation 135 Convergent and Divergent Economic Growth 141 Conclusion 147 SEVEN National Systems of Political Economy 148 Differences among National Economies 149 The American System of MarketOriented Capitalism 150 The Japanese System of Developmental Capitalism 156 The German System of Social Market Capitalism 168 Significance of National Differences 174 Is One System Superior to the Others 175 Do Nations Compete with One Another 180 Convergence Harmonization or Mutual Recognition 183 Conclusion 195 EIGHT The Trading System 196 The Debate over Free Trade 198 Trade and the Economy 202 Revisions of Conventional Trade Theory 206 Postwar Trade Regime 217 The Uruguay Round and World Trade Organization 221 New Threats to an Open Trading System 224 Conclusion 232 NINE The International Monetary System 234 The Postwar International Monetary System 235 The End of Fixed Exchange Rates 238 The Financial Revolution and Monetary Affairs 239 Embedded Technical and Political Issues 242 Devising an International Monetary System 248 Reform of International Monetary Affairs 250 Unity or Fragmentation of the Monetary System 255 Few or Many National Currencies 258 Conclusion 259 TEN The International Financial System 261 Partial Globalization of International Finance 261 Nature of Financial Crises 264 The East Asian Financial Crisis 267 vi C O N T E N T S Controversy over Regulation of International Finance 271 Conclusion 277 ELEVEN The State and the Multinationals 278 Explanations of FDI and the MNC 279 The Multinationals and the International Economy 289 Increased Regionalization of Services and Manufacturing 292 Debate over the MNC and the NationState 294 An International Regime for FDI and MNCs 300 Do Global Corporations Pose a Threat 302 Conclusion 304 TWELVE The State and Economic Development 305 The Rise and Demise of Development Economics 306 Triumph of Neoliberalism 309 The Debt Crisis and Structural Adjustment 313 Theory of the Developmental State 316 The East Asian Miracle Project 321 The East Asian FinancialEconomic Crisis 329 The Future of the Developmental State 331 The Transitional Economies 333 Conclusion 339 THIRTEEN The Political Economy of Regional Integration 341 Economic Theories 344 Political Theories 348 An Eclectic Approach 358 Conclusion 361 FOURTEEN The NationState in the Global Economy 362 The Limited Nature of Economic Globalization 364 Alleged Consequences of Economic Globalization 366 Effectiveness of Macroeconomic Policy 369 The Need for a Historical Perspective 375 Conclusion 376 FIFTEEN Governing the Global Economy 377 Neoliberal Institutionalism 379 The New Medievalism 390 Transgovernmentalism 398 Governance for What 400 Conclusion 402 Select Bibliography 403 Index 411 vii Abbreviations and Acronyms ADC advanced developed or industrialized countries AFLCIO American Federation of Labor and Congress of Industrial Organization APEC AsiaPacific Economic Cooperation BWS Bretton Woods System CAP Common Agricultural Policy ECLA Economic Commission for Latin America EEC European Economic Community Common Market EMS European Monetary System EMU Economic and Monetary Union ERM Exchange Rate Mechanism EU European Union FDI foreign direct investment GATT General Agreement on Tariffs and Trade GDP gross domestic product G7 group of seven major developed economies Group of 77 coalition of less developed countries HST hegemonic stability theory ILO International Labor Organization IMF International Monetary Fund IO international organization IPE international political economy ITO International Trade Organization LDC less developed country MITI Ministry of International Trade and Investment Japan MNC multinational corporation MOF Ministry of Finance Japan NAFTA North American Free Trade Agreement NATO North Atlantic Treaty Organization NBER National Bureau of Economic Research NEG new economic geography ix L I S T O F A B B R E V I A T I O N S A N D A C R O N Y M S NICs newly industrializing countries NIEs newly industrializing economies NGO nongovernmental organization NIEO New International Economic Order OCA optimum currency area OECD Organization of Economic Cooperation and Development OPEC Organization of Petroleum Exporting Countires R D research and development RTA Regional Trade Agreement SDR Special Drawing Right SII Structural Impediments Initiative STT strategic trade theory UN United Nations UNCTAD United Nations Commission for Trade and Development VER voluntary export restraint WB World Bank WTO World Trade Organization x Preface S INCE PUBLICATION of my book The Political Economy of Inter national Relations in 1987 the international economy has experi enced a number of fundamental changes 1 These changes include the end of the Cold War and the victory of democratic capitalism over authoritarian communism the rise of the information or Internet economy and the triumph of neoliberal marketoriented economic ideology deregulation privatization and a decreased role for the state in the economy Important technological advances in telecom munications transportation and information technology have sig nificantly increased the interdependence of national economies These several developments have transformed the international economy and ushered in a new era of economic globalization In addition to these important steps toward the creation of a truly global economy since the mid1980s the world has also witnessed the extraordinary growth of economic regionalism as a countermove ment to economic globalization 2 Western Europe has been the lead ing player in what Jagdish Bhagwati has called the Second Regional ism 3 The North American Free Trade Agreement NAFTA and less formal arrangements in Pacific Asia have along with the European Union moved the world toward regional economic arrangements Regional and other important developments in the real world of eco nomic and political affairs have been accompanied by innovations in economic theory that are highly relevant for an understanding of international political economy IPE Theoretical innovations include the new growth theory the new economic geography and the new trade theory 4 Taken together these novel theories constitute 1 Robert Gilpin The Political Economy of International Relations Princeton Princeton University Press 1987 2 The historic tension between the forces of unification and of fragmentation is the subject of Ian Clark Globalization and Fragmentation International Relations in the Twentieth Century New York Oxford University Press 1997 3 Jagdish Bhagwati and Arvind Panagariya eds The Economics of Preferential Trade Agreements Washington DC AEI Press 1996 2 4 Although I discussed the new trade theory or theory of strategic trade in my 1987 book see footnote 1 above I did not consider it in detail nor did I consider it in conjunction with the new growth and economic geography theories xi P R E F A C E a significant contribution to our understanding of the political econ omy of international relations Thus both real world and theoretical developments have set the stage for this books interpretation of global political economy At one point in my work on this book I intended it to be a second edition of my 1987 book However I eventually realized that the political economic and theoretical changes mentioned above as well as changes in my own thinking about international political economy warranted a wholly new book on the subject This book should be considered a complement to my recent book The Challenge of Global Capitalism The World Economy in the 21st Century 2000 5 Whereas the latter book is primarily an analysis and discussion of the postCold War international economy the present work is more theoretical and focuses more directly on IPE The overlap of the two books is modest and is confined mainly to a few chapters dealing with policy areas such as trade and money In preparing this book I have benefited greatly from the support and assistance of many institutions and individuals My most impor tant debt is to the Woodrow Wilson School and the Center of Interna tional Studies of Princeton University for their financial and other support The Abe Fellowship Program funded principally by the Ja pan Foundation Center for Global Partnership also generously sup ported my research I also wish to thank the John Sloan Dickey Cen ter for International Understanding at Dartmouth College and its director Michael Mastanduno for providing me with an intellectual home during the winter term 1998 Special thanks are due to Joanne Gowa Robert Keohane and Atul Kohli who gave me excellent com ments on an early version of the manuscript Seminars sponsored by the Dickey Center the Department of Political Science of MIT the Department of Political Science at the University of Vermont the Central European University Budapest and the Department of Polit ical Science at Boston College enabled me to receive outstanding criti cisms of my ideas Special thanks are due to Charles Myers of Princeton University Press especially for his patience with missed deadlines and other trying experiences with the author as he shepherded this book through the Press and also to Joan Hunter for her expert and conscien tious copyediting of this book Last but not least special thanks are due to my wife Jean In search of errors duplications and improved clarity she and I have read aloud the text more times than I care to remember Such a practice is a strain on a marriage but hopefully it improves the quality of the book 5 The Challenge of Global Capitalism The World Economy in the 21st Century Princeton Princeton University Press 2000 xii CHAPTER ONE The New Global Economic Order T HIS BOOK analyzes the globalization of the world economy and its real as well as its alleged implications for the international political economy Since the end of the Cold War globalization has been the most outstanding characteristic of international economic affairs and to a considerable extent of political affairs as well Yet as I shall argue throughout this book although globalization had become the defining feature of the international economy at the be ginning of the twentyfirst century the extent and significance of eco nomic globalization have been greatly exaggerated and misunder stood in both public and professional discussions globalization in fact is not nearly as extensive nor as sweeping in its consequences negative or positive as many contemporary observers believe This is still a world where national policies and domestic economies are the principal determinants of economic affairs Globalization and in creasing economic interdependence among national economies are in deed very important yet as Vincent Cable of the Royal Institute of International Affairs has pointed out the major economic achievement of the postWorld War II era has been to restore the level of interna tional economic integration that existed prior to World War I 1 My 1987 book lacked an adequate domestic dimension It analyzed the international economy as if domestic economic developments were of only minor importance In part this neglect was due to my desire to help advance an autonomous selfcontained international political economy The present book attempts to overcome this unfor tunate weakness through a focus on what I call national systems of political economy and their significance for both domestic and international economic affairs As national economies have become more and more integrated the significance of the fundamental differ ences among national economies has greatly increased The 1987 book had several other serious limitations including its treatment of the multinational corporation economic development and economic regionalism although I discussed all three of these important subjects 1 Vincent Cable The Diminished NationState A Study in the Loss of Economic Power in What Future for the State Daedalus 124 no 2 spring 1995 24 3 C H A P T E R O N E at that time much more needs to be said especially in light of subse quent developments In the mid1980s a revolution in international economic affairs occurred as multinational firms MNCs and foreign direct invest ment FDI began to have a profound impact on almost every aspect of the world economy In the 1960s and 1970s increased interna tional trade transformed international economic affairs Subse quently in the 1980s the overseas expansion of multinational firms integrated national economies more and more completely Moreover whereas the term multinational had been synonymous with the expansion of American firms in the 1980s firms of other nationalities joined the ranks of multinationals Most importantly MNCs led the way in internationalization of both services and manufacturing My discussion of economic development in the 1987 book has be come totally outdated scholarship at that time gave serious attention to quasiMarxist dependency theory and the deep division between the less developed and the developed world Today the debate over economic development centers on the appropriate role for state and market in the development process In the conclusion to the 1987 book I referred to economic regionalism as the wave of the future Today economic regionalism has reached flood tide and is having a significant impact on the international economy Financial develop ments since the mid1980s have greatly increased the integration of the world economy and therefore deserve attention This book also addresses the question of whether or not the increased importance of the market in the organization and functioning of the global economy means the end of the nationstate and of international political econ omy as that term is defined in this book Those familiar with my past work will not be surprised to learn that I think not The principal purpose of this book is to draw upon these real world and recent theoretical developments in order to formulate a more comprehensive understanding of international political economy than in my earlier publications The eclectic 1987 book pre sented what I considered to be the three major perspectives on inter national political economy IPEliberalism Marxism and national ism this book takes a consciously realist or statecentric approach to analysis of the international economy Differing from many contem porary writings on the global economy I believe that the nationstate remains the dominant actor in both domestic and international eco nomic affairs Believing that both economic and political analyses are necessary for an understanding of the workings of the international 4 T H E N E W G L O B A L E C O N O M I C O R D E R economy this book integrates these distinct modes of scholarly in quiry Changes in the World Economy This book has been motivated largely by the huge changes in the international economy that have occurred since 1987 The most im portant change of course has been the end of the Cold War and of the Soviet threat to the United States and its European and Japanese allies Throughout most of the last half of the twentieth century the Cold War and its alliance structures provided the framework within which the world economy functioned The United States and its major allies generally subordinated potential economic conflicts to the need to maintain political and security cooperation Emphasis on security interests and alliance cohesion provided the political glue that held the world economy together and facilitated compromises of impor tant national differences over economic issues With the end of the Cold War American leadership and the close economic cooperation among the capitalist powers waned Simultaneously the marketori ented world grew much larger as formerly communist and Third World countries became more willing to participate in the market system this has been exemplified by the much more active role taken by the less developed countries LDCs in the World Trade Organiza tion WTO While this development is to be welcomed it has made the task of managing the global economic system more daunting Economic globalization has entailed a few key developments in trade finance and foreign direct investment by multinational corpo rations 2 International trade has grown more rapidly than the global economic output In addition to the great expansion of merchandise trade goods trade in services banking information etc has also significantly increased With the decreasing cost of transportation more and more goods are becoming tradeables With the immense expansion of world trade international competition has greatly in creased Although consumers and export sectors within individual na tions benefit from increased openness many businesses find them selves competing against foreign firms that have improved their efficiency During the 1980s and 1990s trade competition became even more intense as a growing number of industrializing economies in East Asia and elsewhere shifted from an import substitution to an 2 For a strong attack on globalization and its alleged evils see Richard Falk Preda tory Globalization Oxford Polity Press 1999 5 C H A P T E R O N E exportled growth strategy Nevertheless the major competitors for almost all American firms remain other American firms Underlying the expansion of global trade have been a number of developments Since World War II trade barriers have declined sig nificantly due to successive rounds of trade negotiations During the last half of the twentieth century average tariff levels of the United States and other industrialized countries dropped from about 40 per cent to only 6 percent and barriers to trade in services have also been lowered 3 In addition from the late 1970s onward deregulation and privatization further opened national economies to imports Techno logical advances in communications and transportation reduced costs and thus significantly encouraged trade expansion Taking advantage of these economic and technological changes more and more busi nesses have participated in international markets Nevertheless de spite these developments most trade takes place among the three ad vanced industrialized economiesthe United States Western Europe and Japan plus a few emerging markets in East Asia Latin America and elsewhere Most of the less developed world is excluded except as exporters of food and raw materials It is estimated for example that Africa south of the Sahara accounted for only about 1 percent of total world trade in the 1990s Since the mid1970s financial deregulation and the creation of new financial instruments such as derivatives and technological advances in communications have contributed to a much more highly inte grated international financial system The volume of foreign exchange trading buying and selling national currencies in the late 1990s reached approximately 15 trillion per day an eightfold increase since 1986 by contrast the global volume of exports goods and services for all of 1997 was 66 trillion or 25 billion per day In addition the amount of investment capital seeking higher returns has grown enormously by the mid1990s mutual funds pension funds and the like totaled 20 trillion ten times the 1980 figure Moreover the significance of these huge investments is greatly magnified by the fact that a large portion of foreign investments is leveraged that is they are investments made with borrowed funds Finally derivatives or repackaged securities and other financial assets play an important role in international finance Valued at 360 trillion larger than the value of the entire global economy they have contributed to the 3 Gary Burtless Robert Z Lawrence Robert E Litan and Robert J Shapiro Globa phobia Confronting Fears about Open Trade Washington DC Brookings Institu tion 1998 56 6 T H E N E W G L O B A L E C O N O M I C O R D E R complexity and the instability of international finance It is obvious that international finance has a profound impact on the global economy This financial revolution has linked national economies much more closely to one another and increased the capital available for develop ing countries As many of these financial flows are shortterm highly volatile and speculative international finance has become the most unstable aspect of the global capitalist economy The immense scale velocity and speculative nature of financial movements across na tional borders have made governments more vulnerable to sudden shifts in these movements Governments can therefore easily fall prey to currency speculators as happened in the 1992 European financial crisis which caused Great Britain to withdraw from the European Exchange Rate Mechanism and in the 199495 punishing collapse of the Mexican peso as well as in the devastating East Asian financial crisis in the late 1990s Whereas for some financial globalization exemplifies the healthy and beneficial triumph of global capitalism for others the international financial system is out of control and must be better regulated Either way international finance is the one area to which the term globalization is most appropriately applied The term globalization came into popular usage in the second half of the 1980s in connection with the huge surge of foreign direct investment FDI by multinational corporations MNCs and FDI have been around for several centuries in the form of the East India Com pany and other merchant adventurers In the early postwar dec ades most FDI was made by American firms and the United States was host to only a small amount of FDI from nonAmerican firms Then in the 1980s FDI expanded significantly and much more rap idly than world trade and global economic output In the early post war decades Japanese West European and other nationalities be came major investors and the United States became both the worlds largest home and host economy As a consequence of these develop ments FDI outflows from the major industrialized countries to the industrializing countries rose to approximately 15 percent annually The largest fraction of FDI however goes to the industrialized coun tries especially the United States and those in Western Europe The cumulative value of FDI amounts to hundreds of billions of dollars The greatest portion of this investment has been in services and espe cially in hightech industries such as automobiles and information technology Information in fact has itself become a tradeable and this raises such new issues in international commerce as the protec tion of intellectual property rights and market access for service in 7 C H A P T E R O N E dustries In combination with increased trade and financial flows the increasing importance of MNCs has significantly transformed the in ternational economy Although the end of the Cold War provided the necessary political condition for the creation of a truly global economy it is economic political and technological developments that have been the driving force behind economic globalization Novel technologies in transpor tation have caused the costs of transportation especially transoceanic travel to fall greatly thus opening the possibility of a global trading system In addition the computer and advances in telecommunica tions have greatly increased global financial flows these developments have been extremely important in enabling multinational firms to pursue global economic strategies and operations The compression of time and space resulting from these technological changes has sig nificantly reduced the costs of international commerce Globalization has also been produced by international economic cooperation and new economic policies Under American leadership both the industri alized and industrializing economies have taken a number of initia tives to lower trade and investment barriers Eight rounds of multilat eral trade negotiations under the General Agreement on Tariffs and Trade GATT the principal forum for trade liberalization have sig nificantly decreased trade barriers In addition more and more na tions have been pursuing neoliberal economic policies such as deregu lation and privatization These developments have resulted in an increasingly marketoriented global economy Many observers believe that a profound shift is taking place from a statedominated to a marketdominated international economy Humanity many argue is moving rapidly toward a politically bor derless world 4 The collapse of the Soviet command economy the failure of the Third Worlds importsubstitution strategy and the out standing economic success of the American economy in the 1990s have encouraged acceptance of unrestricted markets as the solution to the economic ills of modern society As deregulation and other reforms have reduced the role of the state in the economy many be lieve that markets have become the most important mechanism deter mining both domestic and international economic and even political affairs In a highly integrated global economy the nationstate ac cording to this interpretation has become an anachronism and is in retreat Many also believe that the decline of the state is leading to 4 The evolution and increasing importance of the market is the subject of John Hicks A Theory of Economic History London Oxford University Press 1969 8 T H E N E W G L O B A L E C O N O M I C O R D E R an open and truly global capitalist economy characterized by unre stricted trade financial flows and the international activities of multi national firms Although most economists and many others welcome this develop ment critics emphasize the high costs of economic globalization including growing income inequality both among and within nations high chronic levels of unemployment in Western Europe and else where and most of all environmental degradation widespread ex ploitation and the devastating consequences for national economies wrought by unregulated international financial flows These critics charge that national societies are being integrated into a global eco nomic system and are buffeted by economic and technological forces over which they have little or no control They view global economic problems as proof that the costs of globalization are much greater than its benefits Foreseeing a world characterized by intense eco nomic conflict at both the domestic and international levels and be lieving that an open world economy will inevitably produce more losers than winners critics argue that unleashing market and other economic forces has caused an intense struggle among individual na tions economic classes and powerful groups Many assert that what former German chancellor Helmut Schmidt called the struggle for the world product could result in competing regional blocs domi nated by one or another of the major economic powers The idea that globalization is responsible for most of the worlds economic political and other problems is either patently false or greatly exaggerated In fact other factors such as technological devel opments and imprudent national policies are much more important than globalization as causes of many if not most of the problems for which globalization is held responsible Unfortunately misunder standings regarding globalization and its effects have contributed to growing disillusionment with borders open to trade and investment and have led to the belief that globalization has had a very negative impact on workers the environment and less developed countries According to an American poll taken in April 1999 52 percent of the respondents had negative views regarding globalization 5 Yet even though globalization is an important feature of the international economy that has changed many aspects of the subject of interna tional political economy the fact is that globalization is not as perva 5 Andrew Kohut Globalization and the Wage Gap New York Times 3 December 1999 sec 1 reporting on a Pew Research Centers national survey in April 1999 which found that 52 percent of all respondents were negative toward globalization Lowincome families were much more negative than wealthier ones 9 C H A P T E R O N E sive extensive or significant as many would have us believe Most national economies are still mainly selfcontained rather than global ized globalization is also restricted to a limited albeit rapidly increas ing number of economic sectors Moreover globalization is largely restricted to the triad of industrialized countriesthe United States Western Europe and to a much lesser extent Japanand to the emerging markets of East Asia Most importantly many of the at tacks on globalization by its critics are misplaced many if not most of its evils are really due to changes that have little or nothing to do with globalization The end of the Cold War and the growth of economic globalization coincided with a new industrial revolution based on the computer and the rise of the information or Internet economy Technological developments are transforming almost every aspect of economic po litical and social affairs as computing power provides an impetus to the world economy that may prove as significant as those previously produced by steam power electric power and oil power The eco nomics profession however has been deeply divided about whether or not computing power represents a technological revolution on the same scale as these earlier advances Although the computer appears to have accelerated the rate of economic and productivity growth it is still too early to know whether or not its ultimate impact will affect the overall economy on a scale at all equivalent to that produced by the dynamo A growing number of economists however believe that computers have an important impact not only on productivity but also on economic affairs in general For example some economists believe that the organization of and the ways in which national econ omies function are experiencing major changes in response to the computer and the Internet Although it is still much too early to gauge the full impact of the computer on the economy it is certain that the computer and the information economy are significantly changing many aspects of economic affairs Most importantly in the industrial ized countries they have accelerated the shift from manufacturing to services financial software retailing etc This pervasive economic restructuring of the industrialized economies is economically costly and politically difficult During the last decades of the twentieth century there was a sig nificant shift in the distribution of world industry away from the older industrial economiesthe United States Western Europe and Japantoward Pacific Asia Latin America and other rapidly indus trializing economies Although the United States and the other indus trialized economies still possess a preponderant share of global wealth 10 T H E N E W G L O B A L E C O N O M I C O R D E R and industry they have declined in relative not absolute terms while the industrializing economies especially China have gained economic importance Before the 1997 financial crisis which began in Thailand and eventually plunged East Asia into political and eco nomic turmoil Pacific Asias economic success had been extremely impressive many of these economies achieved average annual growth rates of 6 to 8 percent And despite the financial crisis such economic fundamentals as high savings rates and excellent workforces sup port the belief that these emerging markets will continue to be impor tant actors in the global economy Economic regionalism has spread in response to these political eco nomic and technological developments Compared to the earlier re gional movement of the 1950s and 1960s the European Economic Community is the only surviving example of that movement the new regionalism has much greater significance for the global economy The movement at the beginning of the twentyfirst century is nearly universal the major economies with a few exceptions that include China Japan and Russia are members of a formal regional arrange ment Regionalism at the turn of the twentyfirst century entails in creased regionalization of foreign investment production and other economic activities Although there is no single explanation for this development every regional arrangement represents cooperative ef forts of individual states to promote both their national and their collective economic and political objectives Economic regionalism is an important response by nationstates to shared political problems and to a highly interdependent competitive global economy As the international economy has become more closely integrated regional groupings of states have increased their cooperation in order to strengthen their autonomy improve their bargaining positions and promote other politicaleconomic objectives Regionalization is not an alternative to the nationstate as some believe but rather embod ies the efforts of individual states to collectively promote their vital national interests and ambitions These developments have made the governance of the global econ omy a pressing issue Effective and legitimate governance requires agreement on the purpose of the international economy During the Cold War the purpose of the world economy was primarily to strengthen the economies of the antiSoviet alliance and solidify the political unity of the United States and its allies this goal frequently necessitated acceptance of trade discrimination and other illiberal policies Today many Americans and others assert that the purpose of governance should be to promote unrestricted free and open mar 11 C H A P T E R O N E kets The global economy and the rules governing it they believe should be guided by the policy prescriptions of neoclassical econom ics and be based on market principles Free trade freedom of capital movements and unrestricted access by multinational firms to markets around the globe should be the goals of international governance With the triumph of the market economic logic and the relative effi ciencies of national economies should determine the distribution of economic activities and wealth and of course of power around the world Critics of globalization on the other hand challenge this em phasis on the importance of free trade and open markets Despite the growing importance of the market historical experi ence indicates that the purpose of economic activities is ultimately determined not only by markets and the prescriptions of technical economics but also either explicitly or implicitly by the norms val ues and interests of the social and political systems in which eco nomic activities are embedded Although economic factors will play an important role in determining the character of the global economy political factors will be of equal and perhaps greater importance The nature of the global economy will be strongly affected by the security and political interests of and the relations among the domi nant economic powers including the United States Western Europe Japan China and Russia It is highly unlikely that these powers will leave the distribution of the global economic product and the impact of economic forces on their national interests entirely up to the mar ket Both economic efficiency and national ambitions are driving forces in the global economy of the twentyfirst century In this book I have taken a political economy approach that integrates economic and political analysis with other modes of schol arly analysis Formal economic theories provide indispensable tools facilitating comprehension of economic developments the conven tional theory of international trade newly gained insights from the theory of industrial organization and other theoretical developments in economic science provide important additional ideas However economic theories alone are not sufficient for an understanding of developments and their significance for economic and political affairs One must also draw upon ideas and insights from history political science and the other social sciences In brief a true political econ omy is prerequisite to an improved comprehension of the implica tions of new developments for international and where relevant do mestic economic affairs The intensity and importance of the debate over the nature of the changing world economy makes one aware of a troubling paradox At the same time that economic issues have moved to the center of 12 T H E N E W G L O B A L E C O N O M I C O R D E R national concerns the discipline of economics itself has become in creasingly remote from the realities of public affairs Over decades the increasing emphasis of the economics profession on abstract mod els and mathematical theories made economics less and less relevant to public discourse and inaccessible not only to the larger public but also to academic colleagues This is especially unfortunate because economics despite its frequently esoteric nature is or at least should be at the heart of public discourse The problem is particularly trou bling because the intellectual vacuum left by economists is too fre quently filled by individuals who misunderstand economics or delib erately misuse the findings of economics in their promotion of one panacea or another to solve the problems of both domestic and inter national economies Intellectual Perspectives In 1987 I identified three ideologies or perspectives regarding the nature and functioning of the international economy liberalism Marxism and nationalism Since the mid1980s the relevance of these perspectives has changed dramatically With the end of both communism and the importsubstitution strategies of many less de veloped countries LDCs the relevance of Marxism greatly declined and liberalism at least for the moment has experienced a consider able growth in influence Around the world more and more countries are accepting liberal principles as they open their economies to im ports and foreign investment scale down the role of the state in the economy and shift to exportled growth strategies Marxism as a doctrine of how to manage an economy has been thoroughly discred ited so that only a few impoverished countries such as Fidel Castros Cuba and Kim Jong Ils North Korea cling to this once strong faith Yet Marxism survives as an analytic tool and a critique of capitalism and it will continue to survive as long as those flaws of the capitalist system emphasized by Marx and his followers remain the boom and bust cycle of capitalist evolution widespread poverty side by side with great wealth and the intense rivalries of capitalist econo mies over market share Whether under the guise of Marxism itself or some other label concerns over these problems will surface in dis cussions of the world economy 6 6 An example is William Greider One World Ready or Not The Manic Logic of Global Capitalism New York Simon and Schuster 1997 Although Greider is not a Marxist his book raises the specter of what Marxists call the underconsumption or glut theory of capitalist crisis that is the contradiction between the capacity of capitalism to produce goods and the inability of workers to purchase these goods 13 C H A P T E R O N E One criticism of my 1987 book was that I did not adequately state my own intellectual position Was I a liberal a Marxist or a nation alist The short answer is none of the above However before giv ing my longer answer I must comment on the three perspectives and on a weakness in my 1987 book I failed to make clear that each of these perspectives is composed of both analytic and normative ele ments Economic liberalism for example is not only an analytic tool based on the theories and assumptions of neoclassical economics but it is also a normative commitment to a market or capitalist economy As I mentioned Karl Marx himself accepted the basic analytical ideas of the liberal economics of his time but he despised capitalisma term he coinedand asked questions that he considered more funda mental than those asked by earlier nineteenthcentury classical econo mists questions about the origins of the capitalist system the laws governing its evolution and its ultimate destiny As Joseph Schum peter has emphasized whereas economists are interested in the day today functioning of the capitalist system Marx and Schumpeter himself were interested in the longterm dynamics of the capitalist system Nationalism or more specifically economic nationalism is also composed of both analytic and normative elements Its analytic core recognizes the anarchic nature of international affairs the primacy of the state and its interests in international affairs and the importance of power in interstate relations However nationalism is also a nor mative commitment to the nationstate statebuilding and the moral superiority of ones own state over all other states Although I accept economic nationalism or what I below call a statecentric ap proach as an analytic perspective I do not subscribe to the normative commitment and policy prescriptions associated with economic na tionalism My own normative commitment is to economic liberalism that is to free trade and minimal barriers to the flow of goods ser vices and capital across national boundaries although under certain restricted circumstances nationalist policies such as trade protection and industrial policy may be justified In retrospect I should have distinguished clearly between economic nationalism as a normative position and political realism as an ana lytic perspective Or to put the matter another way while all nation alists are realists in their emphasis on the crucial role of the state security interests and power in international affairs not all realists are nationalists in their normative views regarding international af fairs Therefore in this book I employ the broader term realism or more specifically statecentric realism to characterize my approach 14 T H E N E W G L O B A L E C O N O M I C O R D E R to analysis of the international political economy But even the very term realism requires further elaboration My Perspective Statecentric Realism Realism is a philosophical position and an analytic perspective it is not necessarily a moral commitment to the nationstate Many real ists in fact lament a world in which the nationstate is not ade quately restrained by international rules and moral considerations Nor is realism a scientific theory As a philosophic or intellectual per spective realism is not subject to the Popperian criterion of falsifi ability and like other philosophic positions such as liberalism and Marxism realism can neither be proved nor disproved by empirical research 7 However international relations scholarship in the realist tradition has led to a number of theories or hypotheses such as the theories of the balance of power and hegemonic stability that can be and have been subjected to empirical testing to determine their validity Several years ago I was asked if there was a difference between realism and nationalism The question startled me as I had always thought that any reader of Hans Morgenthau Hedley Bull and other prominent realist writers would be fully aware that while these schol ars were realists in their analysis of international affairs and their sober expectations regarding human possibilities they were by no means nationalists The realist diagnosing the illnesses of the human condition is not endorsing what he or she sees any more than a physi cian endorses the cancer found in a patient Morgenthaus writings in fact attacked unbridled nationalism and in Politics Among Nations 1972 he set forth rules for diplomatic behavior that could assist nations to live in peace with one another at the same time that they safeguarded their national interests As critics charge Morgenthau may have been naive in believing that it was possible to prescribe moral and diplomatic principles based on his own realist assump tions The point however for Morgenthau and other realists myself included is that realism and nationalism are not identical National ists may be realists but realists are not necessarily nationalists Although realists recognize the central role of the state security and power in international affairs they do not necessarily approve of this situation The teacher who first introduced me to realism as an 7 According to the philosopher of science Karl Popper if an idea or hypothesis etc cannot be refuted at least in principle it is not a scientific statement 15 C H A P T E R O N E analytic perspective Professor George Little of the University of Ver mont was a Quaker pacifist yet when I was an undergraduate Little once chided me for my naive and unrealistic views on a particular development in international politics Martin Wight the author of one of the most important tracts on realism in this century Power Politics 1986 was also a Christian pacifist 8 Even Hans Morgenthau in his influential Politics Among Nations having Adolf Hitler in mind condemned universal nationalism that is imperialistic be havior as immoral One of his basic messages was that states should try to respect the interests of other states 9 It is possible I believe to analyze international economic affairs from a realist perspective and at the same time to have a normative commitment to certain ideals As Michael Doyle reminds us in his Ways of War and Peace 1997 there are many varieties of realist thought 10 Yet all realists share a few fundamental ideas such as the anarchic nature of the interna tional system and the primacy of the state in international affairs However one should distinguish between two major realist interpre tations of international affairs that is between statecentric and sys temcentric realism Statecentric realism is the traditional form of realism associated with Thucydides Machiavelli and Morgenthau as well as many others it emphasizes the state city imperial or na tionstate as the principal actor in international affairs and the fact that there is no authority superior to these sovereign political units this position asserts that analysis should focus on the behavior of individual states Systemic realism or what is sometimes called struc tural realism or neorealism is a more recent version of realist thought and is primarily associated with Kenneth Waltzs innovative and in fluential Theory of International Politics 1979 11 In contrast to state centric realisms emphasis on the state and state interest Waltzs sys temic version emphasizes the distribution of power among states within an international system as the principal determinant of state behavior The statecentric realist interpretation of international affairs makes several basic assumptions regarding the nature of international 8 Wights essay can be found in the collection of his writings edited by Hedley Bull and Carsten Holbraad Power Politics Harmondsworth England Penguin Books 1986 9 Hans J Morgenthau Politics Among Nations New York Knopf 1972 10 Michael W Doyle Ways of War and Peace Realism Liberalism and Socialism New York W W Norton 1997 11 Kenneth N Waltz Theory of International Politics Reading Mass Addison Wesley 1979 16 T H E N E W G L O B A L E C O N O M I C O R D E R affairs Because it assumes that the international system is anarchic this interpretation views the state in the absence of a higher author ity as the principal actor in international affairs The existence of anarchy however does not mean that international politics is charac terized by a constant and universal Hobbesian war of one against all states obviously do cooperate with one another and do create institutions in many areas 12 Anarchy means rather that there is no higher authority to which a state can appeal for succor in times of trouble In addition although the state is the primary actor in interna tional affairs realism should acknowledge the importance of such nonstate actors as multinational firms international institutions and nongovernmental organizations NGOs in the determination of in ternational affairs Realism however insists that the state remain the principal actor The central concerns of the state are its national interests as defined in terms of military security and political independence however statecentric realism does not reject the importance of moral and value considerations in determining behavior While it follows that power and power relations play the major roles in international af fairs power can assume the form of military economic and even psychological relationships among states as E H Carr has pointed out Moreover despite this emphasis on power other factors such as ideas values and norms do play an important role in interstate af fairs 13 The criticism for example that all realists are unaware of the role of ideas or intellectual constructs in international affairs is pat ently false As Morgenthau argued in his classic Scientific Man vs Power Politics 1946 the liberal beliefs of the Western democracies made them incapable of recognizing and being able to react decisively to the threat of fascism in the 1930s Recognizing the importance of ideas Morgenthau warned that it was dangerously unwise to place ones faith solely in the power of ideals 14 In this book I define global political economy as the interaction of the market and such powerful actors as states multinational firms 12 An important critique of the realist emphasis on anarchy is Alexander Wendt Anarchy Is What States Make of It The Social Construction of Power Politics Inter national Politics 46 no 2 spring 1992 391425 13 On the role of ideas or epistemic communities in international affairs consult Peter M Haas ed Knowledge Power and International Policy Coordination In ternational Organization 46 no 1 special issue winter 1992 See also E H Carr The Twenty Years Crisis 19191939 2d ed London Macmillan 1951 14 Hans J Morgenthau Scientific Man vs Power Politics Chicago University of Chicago Press 1946 17 C H A P T E R O N E and international organizations a more comprehensive definition than in my 1987 book The Political Economy of International Rela tions although both take a statecentric approach to the subject 15 While I do assume that the territorial state continues to be the pri mary actor in both domestic and international economic affairs I do not contend that the state is the only important actor Other signifi cant players include the World Bank the International Monetary Fund IMF and the Commission of the European Union Despite the importance of these other actors however I emphasize that national governments still make the primary decisions regarding economic matters they continue to set the rules within which other actors func tion and they use their considerable power to influence economic outcomes The major political players namely Germany France and the United Kingdom are central in even such a highly integrated in ternational institution as the European Union Whatever the ultimate shape of the European Union national governments will continue to be important actors within this regional arrangement My interpretation of international political economy assumes that the interests and policies of states are determined by the governing political elite the pressures of powerful groups within a national soci ety and the nature of the national system of political economy As I argued in War and Change in World Politics 1981 the economic foreign policies of a society reflect the nations national interest as defined by the dominant elite of that society 16 As conceptualists cor rectly argue there is a subjective element in an elites definition of the national interest However objective factors such as the geographic location of a society and the physical requirements of the economy are of great importance in determining the national interest Only objective factors for example can explain why Great Britains fore most national interest for approximately four hundred years was to prevent the occupation of the lowlands Belgium and the Nether lands by a hostile power Clearly British behavior and the numerous wars England fought to keep these lands out of unfriendly hands sug gest that the English nation under many different rulers and political regimes possessed interests that transcended the more narrowly de fined interests of the governing elite of the moment My statecentric position assumes that national security is and al ways will be the principal concern of states In a selfhelp interna 15 Robert Gilpin The Political Economy of International Relations Princeton Princeton University Press 1987 16 Robert Gilpin War and Change in World Politics New York Cambridge Univer sity Press 1981 1819 18 T H E N E W G L O B A L E C O N O M I C O R D E R tional system to use Kenneth Waltzs apt expression states must con stantly guard against actual or potential threats to their political and economic independence Concern with security means that power military economic andor psychologicalwill be vitally important in international affairs states must be continually attentive to changes in power relations and the consequences for their own national inter ests of shifts in the international balance of power Although as Rich ard Rosecrance correctly argues the trading state has become a much more prominent feature of international affairs it is important to recognize that successful development of the international econ omy since 1945 has been made possible by the security system pro vided by the alliances between the United States and its allies in Eu rope and Asia Trading states like Japan and West Germany emerged and grew while protected by American military power moreover toward the end of the twentieth century they established and began to maintain an independent military option 17 Indeed these trading states now possess substantial defensive military forces and defense industries as an insurance policy even Japan with its peace constitution has become one of the worlds foremost military powers One of the most important contemporary critiques of realism is constructivism 18 According to this increasingly influential position international politics is socially constructed rather than constitut ing an objective reality As defined by Alexander Wendt the two ba sic tenets of constructivism are that 1 human structures are deter mined mainly by shared ideas rather than material forces and 2 the identities and interests of human beings are constructed or are the product of these shared ideas rather than being products of nature If valid these ideas undermine not only realism Marxism and liberal ism but also neoclassical economics and much of political science Although constructivism is an important corrective to some strands of realism and the individualist rationalchoice methodology of neo classical economics the implicit assumption of constructivism that we should abandon our knowledge of international politics and start 17 Richard N Rosecrance The Rise of the Trading State Commerce and Conquest in the Modern World New York Basic Books 1986 Rosecrance The Rise of the Virtual State Wealth and Power in the Coming Century New York Basic Books 1999 18 Alexander Wendt Social Theory of International Politics New York Columbia University Press 1999 and Peter J Katzenstein ed The Culture of National Secu rity Norms and Identity in World Politics New York Columbia University Press 1996 19 C H A P T E R O N E afresh from a tabula rasa wiped clean by constructivism is not com pelling Constructivisms principal critique of realism is that realism is purely materialistic and analyzes the political world only in terms of technological forces physical circumstances and other objective factors realists are said to be overly deterministic and to portray a political world over which human beings have no control or agency Constructivism on the other hand is said to emphasize the role of ideas social structures and human volition in political affairs people can construct a better political and more humane uni verse than that described by realists Although I cannot do justice in several paragraphs to these ideas several comments are in order Constructivism makes too great a distinction between realism at least as I use the term in this book and constructivism with respect to the role of ideas ideology and constructs Classical realists from Thucyd ides forward have emphasized the role of ideas and identity in po litical affairs What better example than the powerful idea of nation alism and the importance of national identity that have been staples of realist thought since Machiavelli and Hobbes While constructiv ists are right in stressing the importance of shared ideas and the social construction of the world it is not clear how far they are willing to take this position Ideas are obviously important but the world is composed of many economic technological and other powerful con straints that limit the wisdom and practicality of certain ideas and social constructions Any theory that seeks to understand the world must as do liberalism Marxism and realism seek to integrate both ideas and material forces One of the key ideas in constructivist analysis of international af fairs is the idea of identity or how a society defines itself for exam ple whether a society is democratic or authoritarian in nature affects its behavior According to constructivists realists neglect the impor tance of identity and focus only on material interests and power con siderations In some cases this criticism is valid In general realists do stress interest over identity However many statecentric realists recognize the importance of identity in state behavior for example the nature of the domestic political system As I have already men tioned I myself emphasize the importance of the national system of political economy in determining the economic behavior of individual states Whether a national society defines itself as a stakeholder eg Germany or Japan or a shareholder Great Britain or the United States economy the type of economy has a significant impact on its economic behavior 20 T H E N E W G L O B A L E C O N O M I C O R D E R Political and economic identities or ideologies can have a strong influence on national behavior Certainly one can not explain the Cold War without reference to the ideological conflict between the democraticcapitalist identity of the United States and the totalitarian communist identity of the Soviet Union In fact George Kennan a realist to the core based his containment doctrine on the authori tarian identity of the Soviet state 19 In time Kennan correctly pre dicted the policy of containment would transform this identity and hence the behavior of the Soviet state Morgenthau also emphasized the importance of identity The theme of Scientific Man versus Power Politics was that liberal democratic societies exhibited moral failure when they did not recognize the evil nature identity of Nazi Ger many in the 1930s 20 The sociopolitical nature of a society the na tional ideology and the political identity all contribute to a societys definition of its interests and influence its behavior Realists disagree however with the constructivists position that identity is the most important or the only determinant of a nations foreign policy The statecentric interpretation of international political economy IPE rejects a belief popular among many scholars public officials and commentators that economic and technological forces have eclipsed the nationstate and are creating a global world economy in which political boundaries and national governments are no longer important 21 It is certainly true that economic and technological forces are profoundly reshaping international affairs and influencing the be havior of states However in a highly integrated global economy states continue to use their power and to implement policies to chan nel economic forces in ways favorable to their own national interests and the interests of their citizenry These national economic interests include receipt of a favorable share of the gains from international economic activities and preservation of national autonomy Move ment toward such regional arrangements as the European Union EU and the North American Free Trade Agreement NAFTA exemplifies collective national efforts to reach these goals Many commentators correctly point out that the nationstate in the last quarter of the twentieth century increasingly came under attack from within and from without both transnational economic forces 19 For Kennans views see John Lewis Gaddis Strategies of Containment A Critical Appraisal of Postwar American National Security Policy New York Oxford Univer sity Press 1982 20 Morgenthau Scientific Man vs Power Politics 21 For an early expression of this end of the state thesis see Edward Hallett Carr Nationalism and After London Macmillan 1945 21 C H A P T E R O N E and ethnic nationalisms were tearing at the economic and political foundations of the nationstate Yet the nationstate remains of su preme importance even though there is no certainty that it will exist forever Like every human institution the nationstate was created to meet specific needs The state arose at a particular moment in order to provide economic and political security and to achieve other de sired goals in return citizens gave the nationstate their loyalty When the nationstate ceases to meet the needs of its citizens the latter will withdraw their loyalty and the modern state will disappear as did the feudal kingdoms imperial systems and citystates that it displaced However there is no convincing evidence that such a trans formation in human affairs has yet occurred On the contrary the world is witnessing a rapid increase in the number of nationstates accompanied by creation of powerful military forces 22 Moreover if and when the nationstate does disappear it will be displaced by some new form of formal political authority Economic issues certainly have become much more important since the end of the Cold War and have displaced for the United States and its allies the prior overwhelming concern with military security It is misleading however to draw too sharp a distinction between international economic and security affairs While the weight placed on one or the other varies over time the two spheres are intimately joined always have been and undoubtedly always will be Although the two policy areas can be distinguished analytically it is extremely difficult to isolate them in the real world Their intimate connection was set forth initially by Jacob Viner in his classic Power versus Plenty as Objectives of Foreign Policy in the Seventeenth and Eigh teenth Century 23 As the British economist Ralph Hawtrey demonstrated in his im portant Economic Aspects of Sovereignty 1952 the relationship of economic affairs and national security at least over the long term is 22 In 1945 there were about 50 states in the UN At the end of the century there were nearly 200 They all seek to possess the accoutrements of nationhood currency airlines and national armies Obviously statehood is attractive 23 Jacob Viner Power versus Plenty as Objectives of Foreign Policy in the Seven teenth and Eighteenth Centuries in Jacob Viner The Long View and the Short Stud ies in Economic Theory and Practice Glencoe Ill Free Press 1958 More recent writings on economics and security are discussed in Michael Mastanduno Economics and Security in Statecraft and Scholarship International Organization 52 no 4 au tumn 1998 22 T H E N E W G L O B A L E C O N O M I C O R D E R reciprocal 24 The international political and security system provides the essential framework within which the international economy functions domestic and international economies generate the wealth that is the foundation of the international political system Then over time the economic base of the international political system shifts according to the law of uneven growth 25 the resulting transforma tion of the international balance of power causes states to redefine their national interests and foreign policies Such political changes frequently undermine the stability of the international economicpo litical system and can even lead to international conflict The ways in which the world economy functions are determined by both markets and the policies of nationstates especially those of powerful states markets and economic forces alone cannot account for the structure and functioning of the global economy The interac tions of the political ambitions and rivalries of states including their cooperative efforts create the framework of political relations within which markets and economic forces operate States particularly large states establish the rules that individual entrepreneurs and multina tional firms must follow and these rules generally reflect the political and economic interests of dominant states and their citizens How ever economic and technological forces also shape the policies and interests of individual states and the political relations among states and the market is indeed a potent force in the determination of eco nomic and political affairs The relationship of economics and politics is interactive Purpose of Economic Activity Most economists trained in the discipline of neoclassical economics believe that the purpose of economic activity is to benefit individual consumers and maximize efficient utilization of the earths scarce re sources While other values and goals may be important they are not of fundamental concern to economists qua economists The basic task of economists is to instruct society on how markets function in the 24 Ralph G Hawtrey Economic Aspects of Sovereignty London Longmans Green 1952 Hawtreys book is still one of the very best ever written on the subject of eco nomics and national security A more recent and excellent discussion of the relationship of power and plenty is Theodore H Moran Grand Strategy The Pursuit of Power and Plenty International Organization 50 no 1 winter 1996 176205 25 Gilpin War and Change in World Politics 94 23 C H A P T E R O N E production of wealth and how these markets can be made most effi cient How societies then choose to distribute that wealth among al ternative ends is a moral and political matter lying outside the realm of economic science In the study of political economy however the purpose of eco nomic activity is a fundamental issue Is the purpose of economic activity to benefit individual consumers to promote certain social welfare goals or to maximize national power The question of pur pose is at the core of political economy and the answer is a political matter that society must determine The purpose that a particular society domestic or international chooses to pursue in turn deter mines the role of the market mechanism in the economy Whether a society decides that the market or some other mechanism should be the principal means to determine the allocation of productive re sources and the distribution of the national product is a political mat ter of the utmost importance The social or political purpose of eco nomic activities and the economic means to achieve these goals cannot be separated In every society the goals of economic activities and the role of markets in achieving those goals are determined by political processes and ultimately are responsibilities delegated by so ciety to the state Yet the market has its own logic and its dictates must be heeded as economists are fond of reminding us every benefit has a cost and in a world of scarcity painful choices must be made Therefore the market and economic factors do impose limits on what states can achieve Conclusion The functioning of the world economy is determined by both markets and the policies of nationstates The political purposes rivalries and cooperation of states interact to create the framework of political re lations within which economic forces operate States set the rules that individual entrepreneurs and multinational firms must follow Yet economic and technological forces shape the policies and interests of individual states and the political relations among states The market is indeed a potent force in determination of economic and political affairs For this reason both political and economic analyses are re quired to understand the actual functioning and evolution of the global economy A comprehensive analysis necessitates intellectual in tegration of both states and markets 24 CHAPTER TWO The Nature of Political Economy T HE STUDY of political economy is now very much in vogue among historians economists and social scientists 1 This interest reflects a growing appreciation that the worlds of politics and eco nomics once thought to be separate at least as fields of academic inquiry do in fact importantly affect one another The polity is much more influenced by economic developments than many political scien tists have appreciated and the economy is much more dependent upon social and political developments than economists in general have admitted Recognition of the interrelationships between the two spheres has led to increased attention from historians and social scien tists I shall explore the nature of political economy and contrast it with economics before turning to the subject of international political economy itself During the last two centuries several different definitions of the term political economy have been set forth 2 A brief summary of the changes in those definitions provides insight into the nature of the subject 3 For Adam Smith in The Wealth of Nations 1776 political economy was a branch of the science of a statesman or legislator and a guide to the prudent management of the national economy or as John Stuart Mill the last major classical economist commented political economy was the science that teaches a nation how to be come rich These thinkers emphasized the wealth of nations and the term political was as significant as the term economy In the late nineteenth century this broad definition of what econo mists study was narrowed considerably Alfred Marshall the father of modern economics turned his back on the earlier emphasis on the 1 The references to economists discussed in this section draw from the review of the varieties of political economy in David K Whynes ed What Is Political Economy Eight Perspectives Oxford Basil Blackwell 1984 2 An analysis of various approaches to the subject can be found in James A Capor aso and David P Levine Theories of Political Economy New York Cambridge Uni versity Press 1992 3 This discussion of the various meanings of political economy is based on Colin Wright Competing Conceptions of Political Economy in James H Nichols Jr and Colin Wright eds From Political Economy to EconomicsAnd Back San Fran cisco Institute for Contemporary Studies 1990 25 C H A P T E R T W O nation as a whole and on the political as important In his highly influential Principles of Economics 1890 Marshall substituted the presentday term economics for political economy and greatly restricted the domain of economic science Following Marshalls pre cept that economics was an empirical and valuefree science his disci ple Lionel Robbins in The Nature and Significance of Economic Sci ence 1932 provided the definition to which most presentday economists subscribe Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses In more modern terminology economics is defined by economists as a universal science of decisionmaking under condi tions of constraint and scarcity At the end of the twentieth century the term political economy has come back into fashion even among economists but there are important differences from earlier usages also there is considerable controversy over the meaning of the term For many professional economists especially those identified with the Chicago School polit ical economy means a significant broadening of the scope or subject matter that economists study 4 These economists have greatly ex tended the social domain to which the methods or formal models of traditional economics are applicable The underlying assumptions regarding motivation and the analytical tools of mainstream econom ics they argue are pertinent to the study of all or at least almost all aspects of human behavior For such Chicago School economists as Gary Becker Richard Posner and Anthony Downs the methodology of economicsthat is methodological individualism or the rational actor model of human behavioris applicable to all types of human behavior from individuals choosing a sexual partner to voters choos ing the American President According to this interpretation behavior can be explained by the efforts of individuals to maximize satisfy or optimize their selfinterest Many economists and other social scientists enamored with eco nomics attempt to use the individualistic or rationalchoice methodol ogy of economics to explain social institutions public policy and other forms of social activities that have traditionally been regarded as noneconomic in nature Such economic imperialism identified most closely with the Chicago School covers several scholarly areas that include neoinstitutionalism publicchoice theory and what economists themselves call political economy The essence of this 4 Warren J Samuels ed The Chicago School of Political Economy University Park Pa Association of Evolutionary Economists 1976 26 T H E N A T U R E O F P O L I T I C A L E C O N O M Y approach to social institutions and other sociopolitical matters is to assume that individuals act alone or together to create social institu tions and promote other socialpolitical objectives to advance their private interests Two fundamental positions may be discerned within this broad range of scholarly research On the one hand some schol ars assume that individuals seek to create social institutions and advo cate public policies that will promote overall economic efficiency On the other hand the term political economy is used by neoclassical economists to refer to rentseeking behavior by individuals and groups 5 Trade protectionism is an example of this approach There is however a powerful normative bias among economists that eco nomic institutions or structures are created to serve market efficiency The longterm objective of this body of scholarship is to make en dogenous to economic science those variables or explanations of so cial phenomena that have traditionally been assumed to be exogenous and therefore the exclusive province of one of the other social sciences such as psychology sociology or political science By endogenous economists mean that a particular human action can be fully ex plained as a selfconscious effort of an individual to maximize his or her economic interests for example according to the endogenous growth theory to be discussed in the next chapter a firm invests in scientific research in order to increase its profits By exogenous economists mean that a particular action can be explained best by a noneconomic motive for example Albert Einstein may be said to have been motivated in his work by curiosity or by the desire for fame rather than a desire to increase his income Economic imperialists assume that political and other forms of so cial behavior can be reduced to economic motives and explained by the formal methods of economic science Government policies social institutions including the state itself and even whole economic sys tems these economists claim can be explained through application of formal economic models For example economist Edmund S Phelps broadly defines political economy as the choice of the economic sys tem itself 6 Underlying this sweeping definition of political economy is the conviction expressed by Jack Hirshleifer that economics is the one and only true social science The universality of economics he argues is due to the fact that its analytic abstractions such as scarcity 5 Rentseeking refers to the use of a resource to obtain a surplus over the normal economic return to that resource An example is a tariff that raises the cost of domestic goods 6 Edmund S Phelps Political Economy An Introductory Text New York W W Norton 1985 xiiixiv 27 C H A P T E R T W O cost and opportunities are themselves universally applicable and can be used effectively to explain both individual behavior and social out comes 7 As we shall note many times in this book the belief that there is only one universal social science namely economics is a powerful dogma embraced by many if not most economists At least three different schools of economists employ an economic approach to human behavior neoclassical institutionalism the pub licchoice school and what is sometimes called the new political economy Neoclassical institutionalism attempts to explain the ori gin evolution and functioning of all types of institutions social po litical economic as the result of the maximizing behavior of rational individuals The publicchoice school is also interested in applying the methods of formal economics to analysis of political behavior and institutions especially to the political organization of free men 8 The new political economy is interested primarily in the political determi nants of economic policy Although I shall make only occasional ref erences to these schools of political economists their insights have influenced the argument of this book The publicchoice approach is most closely associated with Nobel Laureate James Buchanan and his coauthor Gordon Tullock 9 Using the framework of conventional economics Buchanan and Tullock in their highly influential The Calculus of Consent 1962 promoted the important subfield of public choice 10 For most economists in the pub licchoice school the subject matter is the same as that of political science they believe that they are applying superior methods of eco nomic science to political affairs 11 What defines the publicchoice school more than anything else however is its political coloration With certain important exceptions such as Nobel Laureates Kenneth Arrow and Paul Samuelson both of whom have made important con tributions to the subject of public choice this school of political econ 7 Jack Hirshleifer The Expanding Domain of Economics American Economic Re view 75 no 6 December 1995 53 8 Wright Competing Conceptions of Political Economy 71 9 A useful overview of the publicchoice literature is Dennis C Mueller The Public Choice Approach to Politics London Edward Elgar 1993 10 James M Buchanan and Gordon Tullock The Calculus of Consent Ann Arbor University of Michigan Press 1962 The relevance of the publicchoice approach to the international economy is set forth in Thomas D Willett The Public Choice Ap proach to International Economic Relations Charlottesville University of Virginia Center for Study of Public Choice 1996 11 The term positive political economy is frequently applied to this position An example is James E Alt and Kenneth A Shepsle Perspectives on Positive Political Economy New York Cambridge University Press 1990 28 T H E N A T U R E O F P O L I T I C A L E C O N O M Y omists especially Buchanan and Tullock themselves is distinguished by its explicitly normative commitment to unfettered markets and strong opposition to government intervention in the economy While some economists emphasize market failures as a reason for govern ment intervention in the economy the more conservative branch of publicchoice economics considers government failurethat is economic distortions caused by the policies of governmentsto be more of a threat to economic wellbeing Politicians and government officials are not the disinterested public servants they are assumed to be by many economists and advocates of government intervention ism they have interests of their own that they seek to maximize in their public activities This position asserts that politicians liberal re formers and others distort the efficient functioning of the market as they use the apparatus of government to further their own private interests Neoclassical institutionalism is one of the most interesting develop ments in contemporary economics According to neoinstitutionalist economists economic institutions and other institutions including the state and their characteristics can be explained by the methods of neoclassical economics Nobel Laureate Douglass C North one of the foremost representatives of this school maintains that economic institutions like all forms of economic activity are the consequence of intentional actions by rational individuals to maximize their eco nomic interests 12 Economic actions may be motivated by the desire to increase economic efficiency or may be simply rentseeking However there is a predilection among neoinstitutionalists and other econo mists to assume that economic institutions have been produced by rational efforts to increase efficiency 13 This neoinstitutionalist school is weakened by the fact that it overlooks the noneconomic factors responsible for the creation of social institutions and the rules govern ing societies Most mainstream economists frequently use the term political economy pejoratively to refer to the selfserving behavior of individ uals and groups in the determination of public policy According to the new political economy national policy is most frequently the 12 Douglass C North Structure and Change in Economic History New York W W Norton 1981 also North Institutions Institutional Change and Economic Perfor mance New York Cambridge University Press 1990 13 A notable example is Richard A Posner The Economics of Justice Cambridge Harvard University Press 1981 A valuable critique of neoclassical institutionalism is Alexander James Field On the Explanation of Rules Using Rational Choice Models Journal of Economic Issues 13 no 1 March 1979 4972 29 C H A P T E R T W O result of private groups efforts to employ public means to further their own private interests rather than the result of selfless efforts to advance the commonweal Economic policy this positon argues is the outcome of distributional politics and competition among power ful groups for private advantage For example the economics litera ture on trade protection endogenous trade theory exemplifies this approach as it argues that tariffs and other obstructions to free trade can best be understood as rentseeking behavior by particular interest groups A very different concept of political economy is used by those crit ics especially Marxists who believe that the discipline of economics has become too formal mathematical and abstract The study of eco nomics as the development of formal models many charge has be come largely irrelevant to the understanding and solving of real social and economic problems A major reason for this isolation of econom ics from the real world they argue is that economics neglects the historical political and social settings in which economic behavior takes place As a consequence some assert that economics at least as it is taught and practiced in traditional departments of economics has little relevance to the larger society and its needs Closely associated with this general criticism is what many critics regard as the pretension of economics to be a science modeled on physics and other natural sciences Economics they contend cannot be valuefree and economists should not pretend that it is According to Marxists and others conventional economics reflects the values and interests of the dominant groups of a capitalist society Rather than being valuefree economics is alleged to be infused with an im plicit conservative social and political bias that emphasizes market and efficiency and neglects such social problems as inequality of in come and chronic unemployment In the opinion of Robert Heil broner and William Milberg contemporary economics is nothing but a handmaiden of modern Western capitalism and its primary pur pose is to make this troubled system work 14 By the end of the twentieth century the term political economy had been given three broad and different meanings For some schol ars especially economists political economy referred to the applica tion to all types of human behavior including behaviors that would not be classified by others as economic of the methodology of formal economics that is methodological individualism or the rational actor 14 Robert L Heilbroner and William Milberg The Crisis of Vision in Modern Eco nomic Thought New York Cambridge University Press 1995 30 T H E N A T U R E O F P O L I T I C A L E C O N O M Y model of human behavior Other scholars used the term to mean em ployment of a specific economic theory or theories to explain social behavior a good example is found in Ronald Rogowskis use of the StoplerSamuelson theorem to explain political outcomes over time and space 15 For those political scientists including myself who be lieve that social and political affairs cannot be reduced to a subfield of economics political economy refers primarily to questions gener ated from the interactions of economic and political affairs Propo nents of this broad approach to the subject are eclectic in their choice of subject matter and methods economic historical sociological po litical etc What You Seek Is What You Find Interpretations of economic affairs are highly dependent upon the an alytic perspective of the observer and upon his or her assumptions as these determine what the observer looks for or emphasizes Funda mental differences between economics and political economy are ex emplified in their differing definitions of the economy to be studied of the basic economic entities or actors and of the forces responsible for economic and more broadly sociopolitical change Members of each academic specialization differ in their perspectives on economic affairs questions asked and methods employed The differences il lustrated in the coming paragraphs are important because they pro foundly influence the ways in which economists and political econo mists study economic affairs at both the domestic and international levels Definition of an Economy In April 1992 the prestigious National Bureau of Economic Research NBER sponsored a conference to analyze whether or not Japan was deliberately creating an exclusive economic bloc in East and South east Asia According to Martin Feldstein NBER director in his charge to conference participants the conference was the first attempt by the Bureau to bring together a group of economists and political scientists the latter included experts on Japanese and international politics to address an issue of mutual concern The results of the conference were published in Regionalism and Rivalry Japan and the United States in Pacific Asia 1993 edited by Jeffrey Frankel an 15 Ronald Rogowski Commerce and Coalitions How Trade Affects Domestic Politi cal Alignments Princeton Princeton University Press 1989 31 C H A P T E R T W O economist and Miles Kahler a political scientist 16 The contribu tions to the book revealed that these two groups of specialists as they attempted to answer Feldsteins questions asked different questions used different methods and reached different conclusions regarding the nature of the evolving Pacific Asia economy The political scientists analysis concentrated on the tradeinvest ment behavior of Japanese firms and on official Japanese foreign aid to the region Official Development Assistance Evidence they as serted revealed that Japanese corporations with the active support of the state were attempting to incorporate the Pacific Asian econo mies into regional industrial and financial structures or networks or ganized managed and dominated by large Japanese corporations Through their trade investment and other activities these giant mul tinational firms working together with Japanese foreign aid agencies were consciously fashioning a regional division of labor composed of highly integrated production and distribution networks centered on the Japanese home economy The political scientists concluded that the Japanese as they had done in the 1930s were again attempting to create and dominate an East Asian sphere of influence albeit this time by peaceful economic means The political scientists defined the Pacific Asian economy as a hierarchical structure increasingly deter mined and dominated by Japanese multinational corporations and the Japanese state The economists on the other hand concentrated their analysis on trade flows and other measurable economic quantities that could be formally modeled Their analysis of the data led to the conclusion that the Japanese state and corporations were not attempting to cre ate an exclusive economic sphere in Pacific Asia On the contrary they insisted that what was taking place in the region could be ex plained entirely in terms of market forces and the responses of indi vidual firms to those forces For example the increasing Japanese in vestment in the region and growing trade with the region were considered responses to the substantial appreciation of the yen fol lowing the Plaza Agreement of September 1985 and to subsequent changes in Japanese comparative advantage Moreover analysis of gross trade statistics showed that although intraregional trade in Pa cific Asia was growing it was growing less rapidly than trade between Pacific Asia and the rest of the world Thus economists found no 16 Jeffrey A Frankel and Miles Kahler eds Regionalism and Rivalry Japan and the United States in Pacific Asia Chicago University of Chicago Press 1993 32 T H E N A T U R E O F P O L I T I C A L E C O N O M Y evidence either for the existence of a distinctive Pacific Asian economy or for any Japanese effort to create a regional sphere of influence Whereas the political scientists analysis defined the Pacific Asian economy as composed of powerful economic and state actors the economists defined the regional economy in terms of economic forces and quantities The opposed conclusions of the two groups of special ists reflected the differences in their basic assumptions about the na ture of economic reality the evidence studied and the methodology employed I believe that the differing analytic approaches and conclu sions of the economists and the political scientists are actually com plementary rather than contradictory Considered together both in tellectual approaches increase awareness of the role of both political and economic factors in shaping economic reality and thereby deepen our comprehension of developments in the world economy Nature of Economic Actors In the late 1960s a group of graduate students in public affairs at Princeton Universitys Woodrow Wilson School of Public and Inter national Affairs asked a professor of economics to offer a course on the multinational corporation MNC During the 1960s the rapid overseas expansion and increasing importance of these giant firms at that time mostly American had captured public attention and be come intensely controversial Raymond Vernon and other commenta tors believed that these business firms would greatly facilitate efficient utilization of the worlds scarce resources and speed economic devel opment of the entire globe 17 However Stephen Hymer and other rad ical critics regarded such powerful corporations as nothing more than instruments of an expanding American capitalist imperialism that was exploiting countries throughout the world 18 The students believed that the MNC was a novel and important phenomenon that should be the focus of at least one course in the Schools substantial econom ics curriculum The students were firmly rebuffed with the professors response that the multinational corporation does not exist Corporations ex ist the economist granted but there is no such thing as a distinctive multinational corporation that behaves differently from other corpo rations Every corporation whatever its nationality or scope of its 17 Raymond Vernon Sovereignty at Bay New York Basic Books 1971 18 Stephen Hymer The International Operation of National Firms A Study of Direct Foreign Investment New York Cambridge University Press 1976 33 C H A P T E R T W O activities behaves in the same way that all others behave All corpo rate leaders make their decisions in response to market signals and in order to maximize their profits Or as the economist told the stu dents the purpose of the postman is to deliver the mail regardless of the color of the uniform Economists in general believe that whether the firm is American European or Japanese it must optimize within given constraints and respond effectively to market opportunities in highly competitive markets or go out of business The fact that a firm happens to be of a particular nationality and competes in a world market through establishment of overseas subsidiaries does not sig nificantly change matters In language that a Marxist or a realist would use the ownership of the means of production and the na tional origins of a business firm are totally irrelevant This experience illustrates the view of neoclassical economics re garding the nature of economic actors The world of the economist is populated solely by individuals consumers and producers pursuing their selfinterest firms states or other economic actors are assumed to be merely aggregates of such individual actors Every individual regardless of ethnicity class or national identity is assumed to act rationally employing a costbenefit calculation in pursuit of his or her selfinterest There are no fundamental differences among Ameri can Japanese or Bantu economic actors Everyone is assumed to be seeking the same broad range of economic objectives The only things that differ from one society to another are the external constraints on decisionmaking and the opportunities among which the individual must choose Within other intellectual perspectives the nature of economic actors appears very different A Marxist for example regards eco nomic classes defined by the ownership or nonownership of the basic means of production or such representatives of class interests as poli ticians or interest groups as the fundamental actors in economic af fairs According to this view all corporations national or multina tional are representatives of the capitalist class that dominates every capitalist economy For proponents of a statecentric approach on the other hand the primary economic actors are nationstates or other powerful political groups and therefore the nationality of the MNC is of great importance because its behavior is strongly influ enced by the policies and culture of its home society Viewed from this perspective a multinational corporation is in its essence a corporation of a particular nationality whose international activities are on the whole intended to promote the primary interests eco nomic political or even security of its nation of origin 34 T H E N A T U R E O F P O L I T I C A L E C O N O M Y Dynamics of the World Economy In September 1992 an important and disturbing event occurred when without warning private investors suddenly transferred huge sums of money out of the British pound the Italian lira and other currencies into the German mark thereby forcing an unwanted deval uation of the pound and other currencies This devaluation signifi cantly reshaped the economic and political landscape of Western Eu rope and tore apart the Exchange Rate Mechanism ERM of the European Monetary System EMS whose purpose was to maintain the values of the European Community currencies within specified narrow bands As a consequence of this financial crisis Great Britain withdrew from the ERM and caused the movement toward European economic and monetary integration to divide into a twospeed pro cess of European unification Interpretations of this episode illustrate the differences between an economic and a political economic analysis of the dynamics of the world economy Economists were certainly aware that political developments like German reunification and the Danish rejection in June 1992 of the Maastricht Treaty had important roles in generat ing the financial crisis of that fall However such political develop ments were treated by economists as factors external to the formal economic modeling of the crisis Economists were interested in the dynamics of the crisis itself and not the political dynamics that led to the crisis Therefore the underlying political and other causes of this crisis were not closely examined by economists Instead analysis of the crisis by economists focused only on its economic aspects For example formulation of a general model of financial crises was a central purpose in one excellent study by economists 19 Political economists on the other hand were more interested in the political genesis of the crisis its political resolution and the longer term economicpolitical consequences That is to say they were most interested in the external or exogenous political factors that lead to a crisis contribute to its resolution and determine its longterm effects The point of this comparison is that economists and political econo mists were interested in different phenomena and asked different questions The 1992 financial crisis illuminated the relationship and 19 This is the case for example of an excellent study of the crisis by Willem H Buiter Giancarlo Corsetti and Paolo A Pesenti Financial Markets and European Monetary Cooperation The Lessons of the 199293 Exchange Rate Mechanism Crisis New York Cambridge University Press 1998 35 C H A P T E R T W O interaction of the economic and political forces that provide the dy namics of the international economy Since the mid1970s the size of international financial flows has grown to hundreds of billions of dollars a day These immense capital flows can easily overwhelm national economies as they did the Italian and British economies in 1992 and many other economies in the late 1990s Increasing integration of global financial markets has caused national governments to surrender a portion of their economic auton omy to global market forces Although a government may pursue inappropriately expansionary economic policies for a time powerful market forces will eventually overturn these policies The huge out flow of capital from Italy and Great Britain in 1992 and subsequent devaluations of their currencies forced both nations to withdraw from the Exchange Rate Mechanism ERM although Italy eventually re turned Many observers believe that the September 1992 financial crisis demonstrated the triumph of transnational economic forces and eco nomic globalization over the nationstate In this popular and influ ential interpretation the integration of global financial markets and the resulting huge flows of capital across national boundaries have led in the words of one enthusiastic writer to the end of geogra phy 20 Some commentators allege that national governments are rap idly losing their economic autonomy and have even become hostage to global market forces and the whims of international speculators Some argue that if a national government fails to heed the interests of the controllers of international capital the errant government will not be able to obtain the capital required to carry out its economic and political plans International capital markets are alleged to have created a web of economic interdependence that has transformed the nature of international affairs and destroyed the economic and politi cal independence of nationstates Hence many have concluded that markets are firmly in control of the world economy Some believe that the 1997 East Asian financial crisis supports this conclusion An alternative interpretation of the earlier 1992 crisis emphasizes the role of government decisions and political developments in con vincing international investors that the currency situation in Western Europe was highly unstable The July 1990 decision to eliminate in traEuropean barriers to capital flows had increased the risk of cur rency speculation that could cause exchange rate disequilibria This 20 Richard OBrien Global Financial Integration The End of Geography London Pinter Publishers 1992 Published for the Royal Institute of International Affairs 36 T H E N A T U R E O F P O L I T I C A L E C O N O M Y potentially risky situation was exacerbated when additional restric tions were placed on exchange rate flexibility within the ERM These economic developments laid the groundwork for the crisis Political developments that raised questions about the movement toward Eu ropean monetary unity included the Danish rejection in June 1992 of the Maastricht Treaty This startling action was followed in Septem ber by the narrow 51 percent passage in France of a national refer endum on the Treaty However the most important developments leading to the financial crisis were the several decisions of the German Central Bank Bundesbank from November 1990 on to raise Ger man interest rates substantially in order to offset the inflationary con sequences of German reunification Then the American Federal Re serve lowered interest rates in early 1992 to stimulate the stagnant American economy Also in order to stay within the ERM currency bands the British government had attempted to maintain an overval ued pound and thereby caused the worst British recession in the post war era These political developments raised serious doubts that the British could continue to maintain the value of the pound The large gap between Germanys excessively high and Americas excessively low interest rates plus the economic troubles of Italy and Great Britain created a disequilibrium in exchange rates Hedgefund managers like George Soros of the Quantum Fund saw an opportu nity for a huge windfall and fled from the overvalued lira and pound to the mark Others followed suit in what economists have called a speculative overreaction Thus although it is correct to say at one level of analysis that Italy and Great Britain were overwhelmed by market forces at a deeper level of analysis it is equally correct to say that the financial crisis was due to policy decisions taken by Ameri can German and British financial authorities Government decisions and the actions of individual economic actors were responsible for that crisis Indeed French government officials economic nationalists to the core denounced the financial crisis as an AngloSaxon plot to destroy the movement toward European unity The 1992 financial crisis illustrates that both impersonal market forces and the deliberate actions of a few powerful states can deter mine the dynamics of the world economy While Italy and Great Brit ain were overwhelmed by market forces deliberate policy decisions by American and German central banks produced such economic fun damentals as the differentials in interest rates Interactions of imper sonal markets and state policies constitute the driving forces in the world economy and the subject matter of the study of international political economy Whereas market forces are the domain of eco 37 C H A P T E R T W O nomic analysis the explanation of economic policies is primarily the province of political economy Because each mode of analysis is lim ited by its assumptions both should be utilized to improve under standing of the dynamics of the world economy The Nature of an Economy Whereas economists regard an economy as a market composed of impersonal economic forces specialists in political economy interpret it as a sociopolitical system populated by powerful actors Such con ceptual differences distinguish the study of economics from that of international political economy IPE The neoclassical economic interpretation is that the economy is a market or a collection of markets composed of impersonal economic forces over which individual actors including states and corpora tions have little or no control As former New York Times economic commentator Leonard Silk has described it for economists the econ omy is nothing more than a collection of flexible wages prices inter est rates and similar forces that move up and down allocating re sources to their profitable use as buyers and sellers rationally pursue their own interests 21 Such an economic universe is a selfregulating and selfcontained system composed solely of changing prices and quantities to which individual economic actors respond Economic actors are assumed to be pricetakers who seek to maximize or at least satisfy their private interests as they respond to changes in rela tive prices or to changes in economic constraints and opportunities The political economy interpretation used in this book defines the economy as a sociopolitical system composed of powerful economic actors or institutions such as giant firms powerful labor unions and large agribusinesses that are competing with one another to formulate government policies on taxes tariffs and other matters in ways that advance their own interests 22 And the most important of these pow erful actors are national governments In this interpretation there are many social political or economic actors whose behavior has a pow erful impact on the nature and functioning of markets This concep tion of the economy as an identifiable social and political structure composed of powerful actors is held by many citizens and by most social scientists other than professional economists 21 New York Times 26 March 1980 D2 22 Ibid 38 T H E N A T U R E O F P O L I T I C A L E C O N O M Y The role of institutions in determining economic behavior and out comes is of particular interest in the political economy interpretation Social political and economic institutions are significant in that they determine or at least influence the incentives that shape the interac tion of individuals and groups as political and economic actors In economics the two principal explanations for the creation of institu tions are neoclassical institutionalism and the theory of public choice Both of these theories assume that institutions can be explained as resulting from conscious action by economic actors to further their economic interests These two positions differ however regarding the purpose of institutions Neoclassical institutionalism is based on the belief that institutions are created primarily to solve economic problems and will result in increased economic efficiency for exam ple neoinstitutionalists believe that business corporations are created to reduce transaction costs The publicchoice position on the other hand believes that government institutions are created by powerful groups public officials and politicians to promote their own self interest and that they decrease efficiency for example tariffs are es sentially rentseeking devices to shift income from consumers to do mestic producers Both positions however explain the creation of institutions as resulting from rational intentions Political economists on the other hand believe that institutions are created for a variety of rational irrational and even capricious mo tives Moreover in contrast to economists emphasis on efficiency or rentseeking the political economists argue that institutions are built on the idea of path dependence and that economic and other institu tions are the result of accidents random choices and chance events that frequently cannot be explained as the result of rational economic processes Institutions are sometimes the consequence of historical ac cident and selfreinforcing and cumulative processes One of my fa vorite examples is the constitutional prohibition against foreignborn Americans becoming President its purpose was to bar the detested Alexander Hamilton from the presidency As a consequence many institutions are neither efficient nor do they necessarily represent the economic interests of the individuals who brought them into exis tence However once these institutions are created for whatever chance or irrational reason they have a powerful advantage over new and more efficient institutions that could otherwise displace them Institutions are even more tenacious than neoinstitutionalism and publicchoice theory suggest and it is frequently difficult to replace an inefficient institution with a more efficient one Neoclassical insti tutionalism for example is based on the assumption of constant re 39 C H A P T E R T W O turns to scale in which economic actors who desire to replace an older and less efficient institution or business firm with a newer and more efficient one can do so without any overwhelming difficulty How ever the established institution or business firm may enjoy economies of scale and hence lower costs merely as a consequence of having established itself in the market ahead of potential rivals An existing institution may also have gained a legitimacy and a powerful constitu ency whose interests it serves Thus even though the potential effi ciency of the new institution or business firm may be much greater than the efficiency of the existing institution or business firm the barriers to entry are too great to accomplish a change In the eco nomic universe of political economists there are many inefficient eco nomic institutions and oligopolistic businesses that result from ran dom events and irrational decisions The study of political economy requires integration of these two fundamentally different meanings of economy Both the neoclassi cal and the political economy interpretations of economic activities are necessary and important ingredients in the effort to understand how the economy functions Impersonal markets and powerful actors interact to produce those economic and political outcomes of interest to students of political economy The study of political economy re quires an understanding of how markets work and how market forces affect economic outcomes as well as an understanding of how power ful actors of which the nationstate is by far the most important attempt to manipulate market forces to advance their private inter ests The science of economics as it has been developed by genera tions of professional economists possesses highly useful analytical tools and a rich body of theoretical insights or as economists prefer models for understanding markets The scope of economic science however is too limited and its theories much too abstract for the purposes of international political economy The strength of political science lies in its broad emphasis on the realities of the universal struggle among human beings groups and states for power and posi tion Its weakness lies in the intuitive nature of its methods and its limited theoretical foundations The study of political economy and international political economy requires an analytic approach that takes into account economics po litical science and other social sciences It must incorporate the many economic political and technological factors that determine or at least influence the nature and dynamics of the international econ omy Yet such an approach will undoubtedly always be limited in its explanatory and certainly in its predictive powers There is simply 40 T H E N A T U R E O F P O L I T I C A L E C O N O M Y too much that we do not know and perhaps never will know As international economist Robert Baldwin has commented an adequate theory of international political economy would have to be built upon a theory of how governments reach decisions and of course there is no such theory 23 Achievement of our goal of comprehending how the international political economy functions will probably always be elusive no matter how hard we work to improve the study of the international economy Embeddedness of the Economy The central idea that markets are embedded in larger sociopolitical systems underlies my interpretation of both political economy and international political economy The government powerful domestic interests and historical experiences determine the purpose of the economy and establish the parameters within which the market price mechanism functions Contrary to economists belief that economic activities are universal in character and essentially the same every where the specific goals of economic activities are in actuality socially determined and differ widely over the face of the earth For example although neoclassical economists assert that the primary purpose of economic activities is to satisfy the desires of individual consumers this characterization applies to the United States but not to every other economy Japan and many Asian societies for example place a high priority on the welfare of the community and on social cohe sion In fact the idea that markets should be free to promote the private interests of individuals is a rather recent belief and the strength of the welfare state in Western Europe indicates that even in the West this idea is not universally accepted In addition to determining the purpose of economic activity the sociopolitical system and a societys values determine the role that the market or price mechanism in a particular society legitimately plays and the socially approved ways in which economic objectives may be pursued Every society has values and beliefs that circumscribe the ways in which the market is permitted to function societies establish rules and set boundaries that govern the range of activities in which the price mechanism is considered legitimate what is considered to be fair economic behavior in one society may not be considered fair in another For example bribery is a serious offense in the United 23 Robert Baldwin in Jaime De Melo and Arvind Panagariya eds New Dimensions in Regional Integration New York Cambridge University Press 1993 41 C H A P T E R T W O States but what Westerners would call bribery has long been a normal and accepted business practice in China Many Americans complain that competition from lowwage Asian labor is unfair many Asians retort that the American criticism is unfair because low wages constitute their only important comparative advantage Such national differences have been a major source of misunderstandings and even of political conflict as national economies have become more closely linked to one another through trade and investment The international economy is also embedded in a sociopolitical sys tem although not as deeply as are national economies the interna tional economy is embedded in an international system of regimes public and private organizations and most important of all nation states As I shall argue in greater detail below the dominant powers in the international system playsplay a major role in defining the purpose of the international economy and the principal rules govern ing international economic activities For example during the Cold War the Western international economic system under American leadership was intended to strengthen security ties against the Soviet Union Economists in general believe that an international economy easily and automatically emerges because in the words of Adam Smith it is natural for mankind to truck barter and trade However it is in fact politically very difficult to create an open world economy As Mancur Olson has pointed out the decision of a government to open its economy to imports and other commercial activities constitutes a politically risky action because it immediately results in many resent ful losers and at least initially produces just a few winners 24 Neces sarily then Olson argues the creation of an international economy is the result of costly actions taken by powerful states hegemons for economic political and especially security reasons Private economic interests especially those of powerful business groups also obviously play an important role in the efforts of powerful states to create an international economy However the political and security interests of states themselves play the central role in its creation 25 The primacy of the national economic and political interests of dominant powers is illustrated in the nature of successive interna tional economies since the midseventeenth century During the mer cantilist age of the seventeenth and eighteenth centuries the major 24 Mancur Olson provides an illuminating discussion of this subject in De Melo and Panagariya eds New Dimensions in Regional Integration 25 The nexus of economic and security affairs is discussed by Edward D Mansfield in his Power Trade and War Princeton Princeton University Press 1994 42 T H E N A T U R E O F P O L I T I C A L E C O N O M Y powers of Western Europe fought on land and sea to create empires that would support their political rivalries Although companies of merchantadventurers such as the British and Dutch East India Com panies benefited from these commercial conflicts the primary concern of states was to acquire a favorable balance of tradepayments to finance their external military and political ambitions Great Britains victory in the Napoleonic Wars resulted in a new and differently or dered international economy Formal imperialism and possession of colonies were deemphasized and what historians called the imperial ism of free trade emerged Or in the words of Stanley Jevons one of Englands foremost economists in the late nineteenth century Un fettered commerce has made the several quarters of the globe our willing tributaries 26 The Pax Britannica and Britains dominant global position were thus built on economic foundations Following World War II the United States launched a concerted effort to create an open world economy The origins of this effort can be traced to the Reciprocal Trade Act of 1934 and the Tripartite Monetary Agreement a few years later In addition American post war planners working mainly with their British counterparts began to lay the foundations for an open world economy following the war this cooperative effort culminated in the Bretton Woods Conference 1944 that created the institutional framework for the postwar inter national economy However strong assertion of American postwar economic leadership occurred only after the emergence of a clear So viet threat With the outbreak of the Cold War the United States undertook a number of important initiatives to strengthen the war torn economies of its allies to forge a powerful antiSoviet alliance and subsequently to fasten these allied economies firmly to the United States The most important American action was of course the Marshall Plan that transferred billions of dollars to Western Eu rope this extraordinary transfer of wealth would not have taken place if not for the Cold War In effect the United States used its political economic and other resources to create an open world economy embracing its political allies and much of the Third World This analysis suggests that the creation and maintenance of an open and unified world economy requires a powerful leader or hegemon that possesses both the political interest and the resources to pay the high costs associated with such a task It is highly unlikely that an open and unified world market economy could be created and main tained unless there were a dominant power able and willing to use its 26 Stanley Jevons The Coal Question London Macmillan 1906 411 43 C H A P T E R T W O political economic and other resources to encourage other states to lower trade and other economic barriers to prevent freeriding and to apply sanctions to states that failed to obey the rules or regimes governing the liberal world economy If there were no such strong leader international cooperation among egocentric states would be exceedingly difficult and there is a likelihood that the open unified world economy would fragment into national protectionism and re gional blocs The emphasis in this book on the role of political actors using their power to influence market outcomes has some similarities to the posi tion of the publicchoice school that argues that all political behavior including that of public officials can be explained as the pursuit of private interests by selfcentered individuals and groups However my position differs from this perspective in important respects The publicchoice school implies that politics and markets can at least in theory be separated it argues that if there were no state intervention in the economy the price system by itself would determine all out comes I believe on the other hand that the market is inherently political For example the distributive effects of markets are deter mined primarily by the nature and distribution of property rights and property rights themselves and their distribution are inevitably affected by political developments Further whereas the publicchoice position believes that public officials are motivated primarily by eco nomic interests I myself believe that national security and prestige play an equal and frequently an even greater role in motivating the behavior of national governments Another difference between the publicchoice position and my own is based on different concepts of the nature of the state and the na tional interest The publicchoice position believes that the state is simply a collection of those individuals who comprise the government at a particular moment the national interest is the combined interests of the individual members of the society or of those members who dominate the government On the other hand I believe that the state is more than the sum of its component parts that it has some auton omy from society and that the national interest is distinct from the combined interests of its parts The state and the national interest cannot be reduced as the publicchoice position asserts to the indi viduals who happen to be in power at any particular moment 27 Most 27 Willett I believe concedes this point when he acknowledges that foreign policy cannot be reduced to interest group politics Willett The Public Choice Approach to International Economic Relations 14 44 T H E N A T U R E O F P O L I T I C A L E C O N O M Y adherents of the publicchoice position believe in free trade as do I However the commitment to free trade must be based on a concept of a national interest and the belief that free trade will benefit that national interest and not just the interests of those in power at the time A state or national government must fulfill several social eco nomic and political functions to retain the loyalty of its citizens Pro vision of security for its citizens both at home and abroad is the pri mary function of the state no other institution can relieve it of this responsibility Another function is to promote the social and eco nomic welfare of its citizens and to guarantee minimal standards of individual justice although the social welfare function has long ex isted as James Mayall has emphasized in discussing what he calls the new economic nationalism economic welfare has become inti mately joined to national citizenship in the modern world 28 Without a state of their own individuals have no access to welfare programs The state also provides an identity for its citizens it appears to be inherent in human nature that individuals need to be part of some larger social grouping In many societies there is growing concern that globalization is leading to loss of a separate identity for individual citizens and individual states This situation reinforces my belief that political economys concept of an economy as markets embedded in a sociopolitical system is not only accurate but that it also provides a very useful tool of analysis Conclusion This book defines political economy as the interaction of the market and powerful actors Both components are necessary and one cannot comprehend how either domestic or international economies function unless he or she understands both how markets work and how states and other actors attempt to manipulate markets to their own advan tage As I stated above markets have an inherent logic of their own as they respond to changes in relative prices constraints and oppor tunities Therefore to analyze the functioning of an economy one must begin with at least a rudimentary knowledge of how the disci pline of economics understands the economy as a market or price mechanism and this is the focus of the next chapter 28 James Mayall Nationalism and International Society New York Cambridge Uni versity Press 1990 chap 6 45 CHAPTER THREE The Neoclassical Conception of the Economy D URING THE past two centuries professional economists have studied the economy as a market system economists from David Ricardo 17721823 to the present have formulated theories to ex plain economic affairs These theories have had a significant influence on the trade monetary and other policies of national governments Because the foundation provided by the discipline of economics is essential to comprehension of the economy as a market this chap ter will discuss the science of economics its strengths and its limita tions The Discipline of Neoclassical Economics In the 1955 edition of his influential textbook Economics Nobel Laureate Paul Samuelson coined the term neoclassical synthesis to characterize the theoretical consensus of professional economists Samuelson was referring to the consensus that economists had achieved through integration of microeconomics associated with Al fred Marshall and other leading economists of the late nineteenth cen tury with the new macroeconomics set forth by John Maynard Keynes in his General Theory of Employment Interest and Money 1936 1 Even though this consensus later broke down in the 1970s when the economics profession fragmented into a number of compet ing schools of macroeconomic thought the term neoclassical econom ics is still used to refer to mainstream orthodox or conventional economics It is applied to the economics of the Keynesian moneta rist or other divergent schools of contemporary economic thought because they all are based on similar assumptions regarding the na ture of the market Perhaps one could say simply that neoclassical economics can be defined as the body of methods and theories ac cepted and utilized by most members of the economics profession In this book I use the term neoclassical economics or simply eco nomics in this general sense 1 John Maynard Keynes The General Theory of Employment Interest and Money New York Harcourt Brace 1936 46 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y Neoclassical economics constitutes a systematic examination of economic affairs as they are defined by professional economists Eco nomics is a discipline or profession into which its practitioners have been thoroughly socialized It is the most systematic and rigorous of the social sciences and the necessary starting point for understanding not only the economy but also many other aspects of society How ever economics is only thata starting point it is the beginning and not the end of analysis The systematic approach taken by neoclassi cal economics provides many advantages but also embodies certain limitations Social reality despite the efforts of economic imperialists and many rationalchoice analysts to persuade us to the contrary cannot be reduced solely to the prices and quantities of economic science Modern economics like physics and the other hard sciences and unlike the other social sciences with the possible exception of demog raphy and certain fields in psychology had a founder or lawgiver who in effect defined the purposes parameters and methodology of the discipline The role of the lawgiver in an academic discipline has been well characterized by Charles Gillispie in his portrayal of Galileo Galilei who founded physics the first science worthy of the name As Gillispie described his genius Galileo earned recognition as the first true physicist and founder of modern physics because he asked the right questions proposed answers hypotheses or theories and cre ated an appropriate methodology experimental techniques with which to test possible answers 2 In such other physical sciences as chemistry and biology there are other creative geniuses who laid the foundations of their disciplines The foundations of a scientific discipline or any academic disci pline for that matter must contain several elements Each discipline requires a commonly accepted definition of the subject and general agreement on the questions that the members of the discipline must attempt to answer Another component is a generally preferred means or methodology the principal method of economics is methodologi cal individualism the rationalactor method which assumes that ra tional selfcentered individuals are the basic economic actors Possi ble answers hypotheses and eventually theories perhaps laws satisfy at least for a time the questions of interest to the discipline The questions methods and answers evolve accumulate and are dis carded over time through open competition among ideas The win 2 Charles Coulston Gillispie The Edge of Objectivity An Essay in the History of Scientific Ideas Princeton Princeton University Press 1960 7 47 C H A P T E R T H R E E ning ideas in this intellectual struggle become part of the everevolv ing consensus of the profession The foundations of modern economics were laid by David Ricardo in the early decades of the nineteenth century 3 Ricardo and his fellow classical economists shared a number of basic assumptions including the idea that everything of value was created by labor the labor the ory of value and a belief that the three basic factors of production land labor and capital could not move across national boundaries Ricardo and other classical economists were particularly interested in learning 1 what laws govern the distribution of income among the factors of production and 2 the determinants of international trad ing patterns that is the composition of the imports and exports of different countries Seeking answers to these questions Ricardo uti lized basic mathematical techniques and formal models that continue to be the accepted methodology of professional economics Ricardo also formulated the law of diminishing returns or rent to account for the distribution of national income and the principle or theory of comparative advantage to explain trade patterns With that principle he explained why Great Britain exported textiles and imported port from Portugal While the questions methods and theories of the eco nomics profession have changed over the past century and a half Ricardos basic approach to the subject has continued to guide his economist successors Economics as the Science of Rational Choice Most contemporary economists would join Paul Samuelson in defin ing economics as the study of choice under conditions of scarcity 4 According to this definition the study of economics originates in the fundamental fact that in a world where everything is scarce choices must be made Economics is the science that guides individuals to make an efficient allocation of scarce resources to alternative and fre quently equally desirable goals In other words modern economics is basically a science of rational choice or decisionmaking under condi tions of scarcity or constraints Economics according to many if not most economists can provide a comprehensive explanation of human behavior based on market principles 5 Every decision whatever benefits it may bring involves a cost or 3 David Ricardo The Principles of Political Economy and Taxation New York E P Dutton 1911 first published in 1817 4 Paul A Samuelson Economics An Introductory Analysis New York McGraw Hill 1967 5 5 Gary S Becker The Economic Approach to Human Behavior Chicago University of Chicago Press 1976 5 48 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y what economists call an opportunity cost In choosing to do one thing one must necessarily forgo the opportunity of doing something else that might be of equal or even greater value As economists fre quently quip There is no such thing as a free lunch TSTFL Even a free lunch involves an investment of time and therefore surrender of an opportunity to do something else In more stark terms every thing incurs a cost as well as a benefit The economists constant awareness that every decision involves a necessary tradeoff between costs and benefits casts a conservative mantle over the social and po litical outlook of the profession and may explain why Thomas Carlyle characterized economics as the dismal science Although some economic theorists such as Adam Smith Karl Marx and Joseph Schumpeter have attempted to comprehend the economy as a complete dynamic and everchanging system of hu man interaction economics in the early twentyfirst century is essen tially a toolbox of formal models and analytic techniques In Keyness words The Theory of Economics does not furnish a body of settled conclusions immediately applicable to policy It is a method rather than a doctrine an apparatus of the mind a technique of thinking which helps its possessor to draw correct conclusions 6 While its methodology provides economics with its analytic rigor it encourages economic theorists to oversimplify economic reality and frequently has no social relevance In the inevitable tradeoff between rigor and relevance economists will choose the former over the latter almost every time One of the highest compliments that one economist can give another is to describe his or her work as robust regardless of its utility in furthering understanding of the actual working of the economic system A formal economic model is an intellectual device used to explain a particular event or variable such a model is an abstraction based on an economic theory Although a model may take a literary form the economics profession ever since publication of Samuelsons Foundations has preferred that models be expressed in formal math ematical and abstract terms Stated simply a formal model contains a number of endogenous variables whose values prices or quantities are determined logically within the model 7 Explanation of an event 6 Quoted in G R Hawke Economics for Historians New York Cambridge Univer sity Press 1980 78 7 Economists frequently state that a particular action is endogenous meaning that the action can be explained by an individuals selfconscious effort to promote his or her economic interests For example if a scientific discovery were motivated by a desire for profits rather than being due to intellectual curiosity one would say that the cause of the discovery was endogenous 49 C H A P T E R T H R E E also requires exogenous or external variables and one or more behav ioral assumptions that connect the exogenous and endogenous vari ables The central behavioral assumption is that individual actors are rational and are always seeking to satisfy their own economic inter ests The exogenous variable or variables are the givens or initial conditions that determine or influence the value of the endogenous variables These explanatory or independent variables are external to the model they could include a change in consumer tastes innovation of a new technology andor other factors Economics then is essentially a collection of formal models ap plied to analysis of specific problems and to an explanation of eco nomic phenomena The fundamental purpose of economic research is to create new models or to extend existing ones 8 The professional training of the economist centers on the task of learning analytic tools and knowing which model is applicable to a particular circumstance To paraphrase Paul Krugman to say that models define the subject of economics means that if there is no model available to explain a particular phenomenon that phenomenon is of little interest to the economics profession regardless of its importance for the real world Krugman has suggested that this explains why little attention has been given to the determinants of economic development an area for which economists have not yet developed an adequate model 9 The utility of a model is situationspecific and as situations are seldom identical it can be difficult to know which model is in fact applicable and whether the model can actually predict or explain the outcome of a particular situation Indeed economists disagree on the validity of various models and on which model is applicable to a particular situation As Charles Kindleberger has commented the an swer to every important question in economics is it depends Or in more formal terms every economic model is qualified by the caveat of ceteris paribus or providing that all other things are equal Be cause all economic theories are partial theories and even such basic laws as supply and demand are contingent on specific circumstances 8 Models play a crucial selective role in determining what economists choose to study If a theory for example cannot be expressed in a formal model that at least in principle is subject to testing then it is very likely not to be of interest to the economics profession What this means in practice is that many ideas and theories that might and I emphasize might explain economic affairs are ignored by economists in favor of ideas that can be tested This tendency leads to the frequently deserved charge that economics lacks relevance Economists would no doubt respond that they would prefer to be irrelevant than to be wrong 9 Paul R Krugman Development Geography and Economic Theory Cambridge MIT Press 1995 50 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y the utility of models is strictly limited Economists must deal with a large number of variables and must employ simplifying assumptions Economics as the Universal Social Science For many economists economics is better defined by its methodologi cal approach than by its precise subject matter As Krugman has noted the tools define the subject for the economist and the domain of economics is determined by the range and applicability of its meth ods Gary Becker an influential proponent of this view sets forth in his book The Economic Approach to Human Behavior 1976 the basic assumptions underlying economics methodology and thus the economic approach to the study of social political and all other forms of behavior The assumptions he discusses are 1 Economics assumes rational endmeans calculations or maxi mizing behavior more extensively and explicitly than do other social sciences 2 Rational or maximizing behavior guides efforts to obtain or maintain stable preferences These preferences are not for spe cific items such as oranges versus apples but for such basic as pects of life as food honor prestige health benevolence and especially wealth Economics assumes that people everywhere re gardless of their social condition differ little on these basics Eco nomics is therefore considered to be a universal science of human behavior and its methods and assumptions are believed applica ble to all times and to all places whether fifthcentury Greece or contemporary industrial Japan 3 Markets develop naturally in order to coordinate with varying degrees of efficiency the actions of different participants 10 The methodology based on these assumptions is known as method ological individualism or the rationalchoice model of human behav ior Economic analysis assumes that individuals individual consum ers producers and households are the only social reality These individuals are further assumed to be rational optimizers that is to say they are individuals who make conscious choices to maximize or at least satisfy their interests at the lowest possible cost to them selves 11 According to this doctrine of constrained optimization 10 Becker The Economic Approach to Human Behavior 314 11 In the economic universe composed of supply and demand factors and prices and quantities individual economic actors are treated as the bearers of these abstract vari ables or of processes explained by a formal model For example a worker is the bearer of a wage demand 51 C H A P T E R T H R E E since every individual exists in a world of scarcity and constraints an economic actor wishes to make the most efficient use of the limited resources available to him or her This rationalchoice model applies only to endeavor and not to outcome An individuals failure to achieve an end or objective due to ignorance or some other cause does not at least in the rationalchoice model of human behavior invalidate the premise that individuals act on the basis of a costbene fit or meansends calculus In the abstract world of the economist all individual consumers are assumed to be alike that is homogeneous All individual produc ers are assumed to be alike also For example every corporation regardless of its nationality or ownership is believed to make its deci sions on the basis of prices market considerations and other objec tive factors and their primary objective is assumed to be increased profits Even though different cultures and historical settings provide differing constraints and opportunities individuals everywhere are still believed to be essentially the same While Americans Japanese and Brazilians find themselves in very different circumstances their basic wants do not differentiate one from the other The environment determines the constraints and opportunities that shape the means available to individuals to reach their goals The belief that individu als everywhere are rational optimizers provides the foundation for the neoclassical economists certainty that economics is a universal sci ence based on the objective laws of the market and is applicable to every economy regardless of its level of development or its culture The behavior of individual consumers and producers in the rational pursuit of their objectives is governed by the principle of marginal utility or marginality On the demand side of the economy according to marginalutility analysis as consumers consume more and more of a good they experience diminishing utility that is while the first ice cream sundae consumed may be devoured with great pleasure each additional sundae provides less pleasure decreasing utility and the demand of the individual for more sundaes decreases On the supply side of the ledger in situations when there are no economies of scale as producers expand production of a given good they begin to en counter diminishing returns and rising costs per unit These diminish ing returns and rising costs mean that at some point the producer no longer has an incentive to produce more of the commodity In effect a small change in one economic variable results in a small change in another economic variable A competitive equilibrium in which the actor has no further incentive to consume or to produce is 52 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y eventually attained through such a process of incremental change The one possible exception to the principle of marginal utility at least for most individuals is the desire for wealth itself a desire that ap pears insatiable The model of competitive equilibrium is intellectually and morally attractive A freemarket competitive equilibrium becomes efficient when demand equals supply in every market and all the resources of an economy are fully utilized Such an equilibrium has been reached when no individual or firm can achieve greater welfare by altering the allocation of resources in any way whatsoever without decreasing at least one other persons welfare this is the concept of the Pareto opti mum discussed below in this chapter In other words the distribution of income and wealth that emerges in such an equilibrium cannot be altered by economic policies without hurting at least one other per son In effect economic policy necessarily must either have no effect or must hurt some group of citizens Therefore most economists be lieve that the role of government should be minimal An important and farreaching implication of these fundamental ideas is that economics and its emphasis on individual choice is appli cable to all aspects of human behavior As a universal science of choice economics has no clear and separate domain of its own but can be used to analyze and understand almost every facet of human behavior Moreover the theories of economic science like those of physics and chemistry are considered objective universal and appli cable across all societies and historical periods The fundamental principles of economic science and its methodology are not limited by boundaries of any kind This proposition that economics is the one and universal social science has been defended by Lionel Robbins in the following words It has sometimes been asserted that the generalizations of Economics the uppercase letter is his are essentially historicorelative in character that their validity is limited to certain historical conditions and that outside these they have no relevance This view is a dangerous misapprehension No one will really question the universal applications of such assumptions as the existence of scales of relative valuation or of different factors of produc tion or of different degrees of certainty regarding the future It is only failure to realize this and a too exclusive preoccupation with the subsidiary assumptions which can lend any countenance to the view that the laws of Economics are limited to certain conditions of time and space 12 12 Lionel Robbins quoted in Lloyd G Reynolds The Three Worlds of Economics New Haven Yale University Press 1971 1920 53 C H A P T E R T H R E E Despite claims of the universality of economic laws economists have extreme difficulty identifying such laws and agreement on the valid ity of any specific law may be impossible to achieve 13 For this reason John Stuart Mill referred to economics as an inexact science and char acterized its laws as tendency laws that is as generalizations regard ing what will happen if no disturbing event should intervene 14 Obvi ously differing national policies and social systems can become intervening variables Nature of a Market The concept of the market as a selfregulating and selfcorrecting smoothly functioning machine governed by objective laws and uni versal principles is at the heart of economics Moreover this concept leads to the conclusion that the freemarket system under certain cir cumstances and assumptions such as complete information and non oligopolistic competition leads to an optimal allocation of given re sources Economists work to define the laws governing markets of all kinds and their principles and generalizations are the best available guide to explain how markets work and to a lesser extent why they sometimes do not work Although all of us have observed and partici pated in markets where goods services and money are exchanged the market conceived by economists is an abstraction or intellec tual construct While some markets may have a physical location like a stock market or an auction many markets do not have a physical existence that one can experience directly Indeed the market econ omy as conceived by economic theory consists only of interdependent equations that are solved continuously and simultaneously Economists believe that a market arises spontaneously to satisfy needs Human beings are by nature economic animals who according to Adam Smith have an inherent propensity to truck barter and exchange To facilitate exchange and improve their wellbeing peo ple create markets money and economic institutions However once a market exists it is believed to function in accordance with its own internal logic and without central direction Coordination among the 13 Obvious candidates are the laws of supply and demand and the law of diminishing returns However even if they do qualify as laws the claim that they are laws of economics rather than physics or psychology is in dispute 14 This discussion is based on Roger E Backhouse Economists and the Economy The Evolution of Economic Ideas 2d ed New Brunswick NJ Transaction Publish ers 1994 225 54 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y activities of individuals participating in a market is spontaneous and is guided by the invisible hand of selfinterest The rational and homogeneous individuals of economic science live in an economic universe composed solely of prices p and quantities q that possess no ethnic national or other identity Changes in prices and quantities constitute the signals to which individuals re spond in their efforts to maximize their goals or as economists prefer their utilities Individual consumers and producers make decisions based on changes in relative prices market opportunities and exter nal constraints Prices at least over the long term are determined by such objective economic laws as the law of diminishing returns and the law of supply and demand The law of demand is the most impor tant of the laws that drive or govern the economy This law holds that people will buy more of a good if the relative price falls and less if the relative price rises people will also tend to buy more of a good as their relative income rises and less as it falls Any development that changes the relative price of a good or the relative income of an actor will create an incentive or disincentive for an individual to acquire or produce more or less of the good This simple yet powerful law of demand is fundamental to the functioning of the market system One of the most important concepts employed by economists to understand market functioning is static equilibrium or simply equi librium An equilibrium exists when there is no tendency for the bal ance between such interrelated variables as prices and quantities to change 15 In less technical language an equilibrium means that no economic actor has an incentive to change his or her behavior and the costs and benefits of the existing situation are judged to have achieved the best balance that an individual could reasonably expect Therefore the potential gains from changing the situation are not worth the potential costs so no change takes place The concept of equilibrium is central to explanations of both eco nomic stability and economic change Neoclassical economics as sumes that markets at least over the long term tend toward an equi librium in which supply matches demand When a disequilibrium exists powerful forces will bring the system back into equilibrium Economists use the term disequilibrium to mean any change in de mand opportunities or relative prices that gives an economic actor an incentive to change his or her behavior in order to increase his or her gains or decrease his or her costs For example an increase in the 15 Fritz Machlup quoted in Yanis Varoufakis and David Young eds Conflict in Economics New York Harvester Wheatsheaf Press 1990 14 55 C H A P T E R T H R E E supply and hence a decline in the price of a good will give some actors an incentive to increase their consumption of the good subject of course to the principle of diminishing returns Over time the imbalance between the increased supply and the increased demand for the good will be overcome and the market will be restored to an equilibrium condition in which no actor has an incentive to change her or his behavior Thus a market equilibrium is defined by econo mists as a system of prices and quantities in which there is a balance between opposing forces The concept of equilibrium is a powerful analytic tool Yet this concept can also be quite misleading Economists generally use the term as if they really could determine at any particular moment whether or not an equilibrium actually exists in a particular market However as Fritz Machlup emphasized the concept of equilibrium is an abstract concept and cannot tell us whether in reality equilibrium actually exists 16 Moreover rather than being a neutral term the con cept may be loaded with policy and political biases The equilibrium concept is central to economists study of the market but there are problems in using equilibrium as an explanatory or predictive tool Markets are highly dynamic and are continually revolutionizing so cieties Certain characteristics of a market economy explain its dy namic nature 1 changes in relative prices in the exchange of goods and services 2 competition as a determinant of individual and insti tutional behavior and 3 the effect of efficiency in determining the survivability of economic actors The markets profound conse quences for economic social and political life flow from these char acteristics The pressures of market competition and the imperative to achieve ever greater efficiency lead to the continuous innovation of new technologies organizational forms and productive techniques and to discarding of the old in what Joseph Schumpeter called a pro cess of creative destruction At both the domestic and international levels a market system creates a hierarchical division of labor and distribution of wealth among producers a division based principally on specialization and the law of comparative advantage Market forces lead to the reordering of society domestic or international into a dynamic core and a dependent periphery The core is character ized principally by its more advanced levels of technology and eco nomic development the periphery is at least initially dependent on the core as a market for its exports and as a source of productive 16 Fritz Machlup Economic Semantics 2d ed New Brunswick NJ Transaction Publishers 1991 4372 56 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y techniques In the short term as the core of a market economy grows it incorporates into its orbit a larger and larger periphery in the long term however due to the growth process and diffusion of productive technology new cores tend to form in the periphery and then to be come growth centers in their own right Examples of these tendencies for the core to expand and to stimulate the rise of new competitive cores and the profound consequences for economic and political af fairs produced by such developments will appear throughout this book Method of Comparative Statics The concept of equilibrium constitutes the foundation of the method of comparative statics one of the most important analytic techniques in the economists toolbox 17 It is a method of analyzing the impact of a change in a model by comparing the equilibrium resulting from the change with the original equilibrium In their analysis of economic change economists rely on this presumed tendency of a market to return to an equilibrium The method of comparative statics is as old as economics itself and was used by David Hume 17111776 in his theory of the pricespecie flow mechanismhis analysis of the do mestic and international effects of a change in a nations balance of payments The method however was not formalized until the 1930s and the 1940s in the work of John Hicks 1939 and in Paul Samuel sons classic Foundations of Economic Analysis 1947 18 Consider ation of this method of comparative statics enables one to appreciate both the strengths and the limitations of the economic analysis of economic change In an equilibrium condition as already noted no participants in a market have an incentive to change their behavior This situation is assumed to continue until an exogenous factor is introduced A change in relative price a technological innovation or a shift in con sumer tastes provides an incentive for economic actors to alter their behavior an exogenous change may also involve imposition of new constraints on economic actors or appearance of new economic op portunities In response say to a change in relative prices a rational economic actor will have an incentive to maximize gains or minimize losses Or a new technology that reduces the cost of producing a 17 For a technical discussion of the method consult Paul A Samuelson Foundations of Economic Analysis Cambridge Harvard University Press 1983 78 18 Ibid 57 C H A P T E R T H R E E particular good might be adopted by an entrepreneur to cut costs expand market share andor increase income Then competitors would either have to adjust to this development or else be forced out of business in either case the exogenous change has powerful ramifications throughout the economy as actors adjust to its conse quences When equilibrium is restored there is no longer any incen tive for actors to change their behavior until another exogenous change enters the market Exogenous developments that cause disequilibrium and give indi viduals an incentive to change their behavior are frequently quite mi nor and may require little more than a small adjustment by the eco nomic actors This means that the evolution of an economy is a generally continuous and relatively smooth process consisting of an equilibrium a destabilizing disequilibrium and eventual creation of a new equilibrium Economists agree with Gottfried Leibnitz 1646 1716 that nature does not take jumps and that change tends to be incremental 19 However upon occasion exogenous developments can be revolutionary and can cause a profound shock to the economy then the resultant adjustment or transition to a new equilibrium can have significant implications for both economic and political affairs The sudden large increase in petroleum prices in 1973 exemplified dramatically how a change in relative prices could have a dispropor tionately huge impact on international economic and political affairs when the increase in world energy prices plunged the world economy into a decade of economic stagflation Throughout the 1970s and beyond the economies of the world struggled to adjust to this dra matic increase in energy prices According to neoclassical economics the outcome of a disequilib rium is totally dependent upon the interplay of economic forces and the interaction of many individual decisions responding to changes or anticipated changes in relative prices The focus of analysis is on the disequilibrium itself and on the economic forces it generates The his tory of the events leading up to the disequilibrium or initial condi tions is not relevant for the outcome or to restoration of an equilib rium As Paul Samuelson has argued whatever initial conditions may be eventually prices and quantities converge to a new equilibrium 19 For example an economist wrote that the stock market crash of October 1987 could not have been caused by such a small event as the AmericanGerman clash over interest rates Causes and effects he argued must equal one another Chaos theory on the other hand teaches us that small events can have disproportionately large conse quences 58 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y without regard to initial conditions 20 In other words history is gener ally irrelevant to an economic explanation of an event All one needs to know is the vectors and the strength of the forces at work The attitude of economists toward dynamics is not unlike that of physi cists a physicist does not need to know the history of a baseball game nor have a detailed knowledge of the batter to calculate the trajectory of a batted ball Nevertheless introduction of the idea of path depen dence into economic analysis has helped moderate antihistorical thinking in economics Although the method of comparative statics is a powerful tool of analysis its usefulness as a means of understanding economic change in the real world is severely limited The method cannot provide an analysis of the historical forces responsible for the original equilib rium position nor of the transitional process involved in the move from one equilibrium position to another In effect economics cannot account for the causes of the disequilibrium because the exogenous variables that produced the equilibrium lie outside the realm of eco nomic analysis Moreover economics cannot predict nor is it con cerned with the course of historical events that lead to the new equi librium yet as the path dependence concept informs us the many important developments on the way to the new equilibrium will have a determining effect on the nature of the new equilibrium and hence on the overall condition of the economic system Finally even though an economic system eventually finds a new equilibrium the system never returns to the old equilibrium In brief the world has been transformed but economics is of no more than limited utility in ex plaining the outcome and how it was achieved At the time of the 1973 oil crisis some economists argued that the price rise was caused solely by market forces The high inflation of the late 1960s and early 1970s they asserted had caused a wide gap or disequilibrium between the nominal price and the real price of petroleum According to this interpretation the oil price change was merely a rapid movement toward the new equilibrium between the price and the supply of petroleum While this comparative statics analysis does indeed tell part of the story it omits the crucial role played by the Yom Kippur War between Israel and its Arab neighbors and the impact of the oil price rise on world affairs It is actually highly doubtful that the huge rise in the price of oil would have taken 20 Paul Samuelson quoted in Rod Cross ed Unemployment Hysteresis and the Natural Rate Hypothesis Oxford Basil Blackwell 1988 3 59 C H A P T E R T H R E E place at least at that time if the ArabIsraeli war had not occurred In addition the ways in which different countries adjusted to the oil shock and returned to equilibrium had profound consequences for the world economy Whereas the United States responded to the de flationary effects of the oil price rise with efforts to stimulate its econ omy West Europeans were more concerned about the inflationary effects and restrained their economies Important policy conflicts re sulted from these differing responses and the conflicting paths chosen by the United States and other major economies contributed to insta bilities in the world economy throughout the 1970s Economic analysis is a necessary ingredient in any effort to under stand the dynamics of the world economy indeed the comparative statics analysis of the oil price rise is very useful However economics provides only a partial explanation of the event and leaves out such essential parts of the story as the war that triggered it the different paths taken toward new equilibria and the overall consequences for the international economic and political system While it would be too much to expect the method of comparative statics to take account of these matters the point is that economic analysis alone does not substitute for historical political and sociological analysis Intellectual Limitations As many economists themselves acknowledge economics has a num ber of intellectual limitations that weaken both its claims to be an exact science and its usefulness as an analytic tool Perhaps most im portant of all certain assumptions underlying economics are unrealis tic For example the central assumption of individual rationality has frequently been demonstrated to be inaccurate 21 Nor is the assump tion that an economic actor has complete information always correct And markets are frequently not the perfect competitive markets they are assumed to be by conventional economic analysis Even though they have given considerable attention to these issues and have dealt with them in various ways economists still assume that such prob lems are exceptions rather than inherent limitations Economists have given increased attention to the problem of uncertainty yet there has been a tendency to ignore the problem of uncertainty andor to wish 21 An attack on the assumption of rationality is found in the research of Daniel Kah neman Consult his New Challenges to the Rationality Assumption Journal of Insti tutional and Theoretical Economics 150 no 1 1994 1835 60 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y it away Economists do however utilize various techniques to side step difficulties raised for economic analysis by the unrealistic as sumptions of their discipline Economists treatment of uncertainty and technological change provides a valuable illustration of unrealistic assumptions Although the profession recognizes technological advance as the most impor tant determinant of longterm economic growth and hence the most important factor propelling economic change in the modern world it also acknowledges that technological innovation is uncertain and unpredictable by its very nature Nevertheless Gene M Grossman and Elhanan Helpman in their pioneering Innovation and Growth in the Global Economy 1991 explicitly base their analysis of techno logical advance and its consequences on the unrealistic assumption of certain and complete information about the nature and consequences of technological innovation 22 The very nature of technological devel opments on the other hand is that they and their effects are highly unpredictable From my perspective one of the most important intellectual limita tions of economics is its neglect of the role of the state in economic affairs and especially in international economic developments The discipline focuses on the behavior and interactions of autonomous individuals and enterprises responding to impersonal market signals It is obvious of course that economists are well aware that national policies and activities can be relevant for economic outcomes How ever political considerations tend to be either ignored or conveniently forgotten 23 Economists formulate laws of economic behavior on the assumption that markets count and states do not Although many economists acknowledge the unrealistic assump tions underlying economic science and do their best to transcend them many and perhaps even most would agree with Milton Fried mans methodological prescription that it is of no significance whether or not the assumptions underlying economics are realistic 24 What is important according to Friedman is whether those assump tions lead to fruitful propositions that can be tested empirically and thereby shown to be valid or invalid In other words do the assump 22 Gene M Grossman and Elhanan Helpman Innovation and Growth in the Global Economy Cambridge MIT Press1991 23 Benjamin J Cohen Organizing the Worlds Money The Political Economy of International Monetary Relations New York Basic Books 1977 41 24 Milton Friedman The Methodology of Positive Economics in his The Method ology of Positive Economics Chicago University of Chicago Press 1953 343 61 C H A P T E R T H R E E tions of rational individuals perfect markets and complete informa tion enable economists to make accurate predictions about economic behavior In principle of course Friedman is quite correct that what is im portant is the empirical testing of a theory However his attack on those who call for realistic assumptions would be more convincing if economists predictions and forecasts were indeed as accurate as he apparently assumes Also if economists really did choose among the ories solely on the basis of empirical evidence Friedmans argument would be strengthened However as Donald McCloskey has noted few theories are tested empirically and economists choose theories for a number of ideological philosophical and in his language rhetori cal reasons More devastating is the fact that few theories or hypoth eses meet the Popperian test of falsifiability In other words they can not be tested empirically to determine their validity Moreover economics like the other social sciences is frequently hampered by absence of a counterfactual against which a theory may be tested 25 In addition economists frequently redefine the terms of a theory to make it consistent with empirical evidence A notable example rele vant to this book was the discovery by Wassily Leontief that the United States had a comparative advantage in agriculture which at the time of his research was considered to be a laborintensive activ ity 26 Prior to Leontiefs research conventional trade theory had pre dicted that the United States should have a comparative advantage in capitalintensive goods To resolve what became known as the Leon tief Paradox economists introduced the concept of human capi tal According to this reformulation of the meaning of capital the comparative advantage of the United States in agriculture was ex plained by the fact that it had invested heavily in agricultural skills knowledge and equipment Broadening the concept of capital to in clude human capital greatly weakened the predictive power of con ventional trade theory based on the idea of factor endowments This modification of the definition of capital and by implication of conventional trade theory raises the important epistemological 25 Donald N McCloskey The Rhetoric of Economics Madison University of Wis consin 1985 On the failure to meet the test of verifiability consult Mark Blaug Disturbing Currents in Modern Economics Challenge 41 no 3 MayJune 1998 1134 interview with Mark Blaug The Problem with Formalism Challenge 41 no 3 MayJune 1998 3545 26 WW Leontief Domestic Production and Foreign Trade The American Capital Position Reexamined Proceedings of the American Philosophical Society 97 Sep tember 1953 33249 Reprinted in Readings in International Trade ed H G John son and R E Caves Homewood Ill R D Irwin 1968 62 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y question of whether or not the idea of human capital is a logical extension of the conventional theory of international trade based on factor endowments or whether it actually is an ad hoc hypothesis intended to rescue a theory that is crumbling in the face of contrary evidence As Thomas Kuhn demonstrated in The Structure of Scien tific Revolutions 1962 scholars and scientists are frequently strongly tempted to resort to ad hoc hypotheses to defend a long accepted truth that has become subject to serious attack 27 In fact use of ad hoc hypotheses and of ex post facto redefinitions of impor tant terms in a theory makes it difficult to prove a theory or hypothe sis wrong Proponents of a theory whose validity is threatened by contrary evidence sometimes merely change the terms of the theory to make it conform to the empirical evidence Modification of the meaning of capital in the above example suggests that economists do change their assumptions in order to make their predictions work At the least the inclusion of human capital significantly enlarged and modified the content of conventional trade theory The predictions of economists are in fact notoriously poor As some quip Economists have successfully predicted seven of the last five recessions Moreover a significant portion of the accepted body of economic theory has never been adequately tested For students of political economy the ceteris paribus other things being equal ca veat offered by economists is exceptionally significant because politi cal factors and social institutions do affect the outcome of economic activities and are rarely equal in their consequences For this reason alone the problem of the validity of the assumptions on which eco nomics is based cannot be as easily dismissed as Friedman and other economists would like Economists efforts to employ econometrics the principal mathe matical techniques to test theories against facts have produced only moderate success in resolving theoretical controversies While econo metrics has had many successes it has failed to transform economics into the formal and mathematical science foreseen by Samuelson Suc cessful application of econometrics has been limited by the lack of good data and the sheer complexity of the economy In the harsh judgment of The Economist econometric studies have not settled a single major theoretical dispute 28 Moreover many if not most eco nomic theories are never submitted to empirical testing In the ab 27 Thomas S Kuhn The Structure of Scientific Revolutions Chicago University of Chicago Press 1962 28 The Economist 9 May 1987 6869 63 C H A P T E R T H R E E sence of empirical testing of their theories strong differences flourish Rather than a theoretical consensus on macroeconomics one encoun ters Keynesians New Keynesians PostKeynesians Classicists New Classicists monetarists proponents of rational expectations and other fractious schools of economists all using formal mathematical techniques and coming to quite different conclusions largely because they start with differing assumptions Another problem limiting the usefulness of economics as an ana lytic tool is found in large and important subfields of economics that have never been tested or are in fact nonempirical and therefore not really testable One such subject is the field of industrial organization The theory of industrial organization has made major theoretical strides especially through application of the model of noncooperative games from game theory a development that has made industrial organization one of the most theoretically developed subfields of eco nomics Even so the field of industrial organization is confronted by the serious methodological problem that although many alternative models of corporate behavior applicable to specific industries have been developed there is still no general model or overarching theory of industrial organization In fact as Joseph Stiglitz has observed economists do not even agree on the fundamental model for analyzing or describing the economy 29 As Daniel Bell and Irving Kristol have pointed out most economic controversies involve differences over the nature of economic reality 30 And prospects for a science of economics are indeed limited without agreement on the nature of the economy itself that is which economic models should be applied to describe the market This leads to a situation where political and ideological biases play a larger role in the acceptance of theories than economists generally admit 31 Economists assumption that economics is a universal science appli cable to all times and places can lead to analytic distortions and faulty policy prescriptions Their inability or unwillingness to recognize the significance of differences among states and societies andor the in fluence of cultural and historical settings limits the usefulness of eco nomics The imposed policy prescriptions of the International Mone tary Fund IMF following the East Asian financial crisis provide an 29 Joseph E Stiglitz Another Century of Economic Science Economic Journal 101 no 404 January 1991 13439 30 Daniel Bell and Irving Kristol eds The Crisis in Economic Theory New York Basic Books 1981 viii 31 John Tiemstra Why Economists Disagree Challenge 41 no 3 MayJune 1998 4662 64 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y unfortunate example of economists failures to comprehend local social and political conditions An understanding of the international political economy must be based on appreciation of state policies social norms and institutions and historical legacies and also of the ways in which economic outcomes are shaped by such external factors Although neoclassical economists claim that economics is an objec tive science like physics economics is actually built upon a number of normative assumptions or value judgments accepted by most econ omists These normative assumptions influence the choice of subjects that economists study and the answers they will accept Economics offers many conflicting explanations of the causes of trade flows and the determinants of exchange rates indeed value preferences fre quently play a significant role in determining which model a particu lar economist accepts or rejects In this way normative assumptions sometimes influence economists policy prescriptions Although one may share some of their assumptions as I do including the desirabil ity of free trade and of open economies these assumptions can have a distorting effect on analysis and resulting policy recommendations Modern economics based on the philosophy of political liberalism assumes that the individual rather than groups or classes is the basic unit of society 32 and that there is a harmony of interests among indi viduals at least over the long term with this harmony accounting for social and political stability The underlying harmony in a market system is the result of what Adam Smith called the invisible hand which means that the actions of each individual as he or she pursues selfish interests lead automatically to betterment of the human race Belief in the harmony of interests among individuals also constitutes the basis of the liberal belief in moral and social progress Liberals argue that despite frequent setbacks history is moving toward achievement of the greatest good for the greatest number Liberalism incorporates a normative commitment to individual rights the free market and political democracy Or to put the point differently liberal thought tends to believe that all good things go together As Charles E Lindblom has pointed out political democ racy and economic liberalism have tended generally to accompany one another in the modern world 33 Tension does exist however be tween liberalisms commitment to equality equity and its commit 32 The idea that society is composed of conflict groups of which the state is the principal example was set forth by Ralf Dahrendorf Class and Class Conflict in Indus trial Society Stanford Stanford University Press 1959 33 Charles E Lindblom Politics and Markets The Worlds Political Economic Sys tems New York Basic Books 1977 65 C H A P T E R T H R E E ment to freedom liberty The split between those liberals who give priority to one or the other of these fundamental values underlies dissension in modern democracies over the role of the state in the economy Americans apply the term liberals to those partisans who give precedence to equality and therefore urge government interven tion in the economy to promote equality Conservatives on the other hand give precedence to liberty and at least in principle oppose gov ernment intervention in the economy From this perspective both Franklin D Roosevelt with his New Deal policies of state interven tion in the economy to promote economic equality and Ronald Reagan whose economic policies Reaganomics began to roll back the New Deal in the interest of economic freedom were liberals They simply placed a differing degree of emphasis on equality versus liberty An important normative assumption held by mainstream econo mists is that the purpose of economic activity is to increase the wel fare of the individual consumer and to maximize global wealth The harmonyofinterest doctrine assumes that if the market is left alone and prices are right resources will be employed efficiently and over the long term everyones welfare will improve Such beliefs lead to the conclusion that the state should not intervene in the economy Politicians economists believe invariably get prices wrong and thereby distort the efficient functioning of the market Defining economics as a science of efficient resource allocation economists tend to have a strong bias in favor of efficiency over eq uity That is economists generally prefer the efficient allocation of economic resources to maximize production of wealth rather than distribution of wealth according to some subjective standard of what is fair This emphasis on the driving force of efficiency encourages economists to believe that despite frequent setbacks caused by such developments as war trade conflicts and other disruptions the world is moving inexorably in the direction of free trade and a global mar ket economy The movement toward integration of national econo mies and increasing global economic interdependence has developed because markets are more efficient than other forms of economic or ganization 34 The collapse of the Soviettype command economy strongly reinforced this conviction Most neoclassical economists accept implicitly the existing distribu tion of wealth and property rights Yet economists have of course 34 This argument is set forth in John R Hicks A Theory of Economic History Lon don Oxford University Press 1969 66 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y addressed the equityefficiency tradeoff and have also carried out re search on the most efficient distribution of wealth and property rights to achieve the social conditions most conducive to rapid economic growth Many economists have strong personal concerns about wealth inequities even an economic conservative like Milton Fried man has proposed a negative income tax as a solution to growing inequalities in American society Nevertheless concern over the distri bution of income lies outside the primary focus of the discipline In stead economists generally accept and seldom challenge the legiti macy of the status quo distribution of wealth and property rights in society an attitude that sometimes leads to indifference to social is sues An admittedly unscientific survey of Princeton University econo mists regarding the economic priorities of the first Clinton Adminis tration revealed such a conservative social bias All but one of the halfdozen economists interviewed proclaimed that the newly elected Presidents first priority should be to leave the economythen in a recessionalone The one exception was the economistpresident of Princeton Harold Shapiro who stressed the importance of maintain ing healthy social welfare programs 35 At the international level economists generally assume what Charles Kindleberger calls a cosmopolitan rather than a nationalist stance 36 With few exceptions economists believe in free trade and oppose protectionist practices they strongly believe that open and unrestricted markets are the best way to increase consumer choice and maximize efficient use of the planets scarce resources At the same time however economists qua economists place a low priority on the distribution of wealth within and among national economies They eschew the controversial issue of distributive justice because it involves a value judgment and thus lies outside the realm of eco nomic science Many critics regard mainstream economics as politi cally conservative and therefore tolerant of the evils of the domestic and international status quo Indeed the beliefs that resources are scarce and must be used efficiently and that hard choices must be made among alternative uses reinforce the conservative bias pervad ing the discipline Economists in general believe that trade and economic intercourse promote peaceful relations among nations because the mutual bene fits of trade and expanding interdependence foster cooperative rela 35 Princeton Alumni Weekly 10 March 1993 56 36 Charles P Kindleberger Power and Money The Economics of International Poli tics and the Politics of International Economics New York Basic Books 1970 67 C H A P T E R T H R E E tions Whereas politics tends to divide economics is believed to unite peoples A liberal world economy based on openness and free trade should have a moderating influence on international politics because it creates bonds of mutual interest and a commitment to the status quo However it is important to emphasize again that although ev eryone will or at least could benefit in absolute terms under a system of free exchange individual relative gains will differ depending on the marginal contribution to the social product made by those indi viduals This issue of relative gains and the uneven distribution of the wealth generated by the market system has given rise to Marxist and nationalist criticisms of economic liberalism Neoclassical economists believe that markets should be left alone by politicians Except in rare cases of market failure the government should neither intervene in the economy nor try to influence market outcomes Economists use the term market failure to describe a situation in which markets fail to produce either economically opti mal or socially desirable outcomes and they define four principal types of market failure One type occurs when there are externalities or spillovers of economic activities so that one actors economic activities harm those of another as in environmental pollution In creasing returns and declining marginal costs that lead to a monopoly constitute another type of market failure Still another is found in such market imperfections as market rigidities and consumer lack of information And a more controversial type is distributional inequali ties While most economists acknowledge market failures they are far from agreement on ways to resolve such failures There is a partic ularly clear difference of opinion about income inequalities Although there is intense controversy within the economics profes sion concerning market failure and what if anything should be done about it most economists would agree that the problem of govern ment failurepolicies that distort the market and cause gross ineffi cienciesconstitutes a more serious problem This laissezfaire atti tude holds that if the market were left alone it would get prices of wages profits and rents right incentives and disincentives would encourage individuals to make their maximum contribution to the economy and the economy would produce optimum outcomes for society On the other hand economists believe that government inter vention in the economy invariably gets prices wrong distorts incen tives and produces economic outcomes that are suboptimal for the society as a whole Finally commitment to Pareto optimality provides a guiding nor 68 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y mative principle for economics 37 As a moral principle for individuals this idea cannot be faulted However its relevance for the real world of political affairs is not only dubious but the principle is highly questionable in political terms because it assumes that absolute gains are important but related losses are insignificant 38 Statecentric ana lysts on the other hand stress the importance of relative gains or losses as much or more than absolute gains This difference in emphasis can be crucial to evaluation of a partic ular development For example viewed by the criterion of Pareto op timality an absolute gain to one state is justifiable However a state centric assessment could be very different A case in point would be an absolute gain in the wealth and hence in the power of an aggres sive state such as Nazi Germany in the 1930s Such a development would have been morally justifiable according to the Pareto criterion However in political terms a wealthier Nazi Germany could shift the international distribution of power in favor of that potentially aggressive state and thus the likelihood of war could increase Econo mists emphasis on absolute gains and statecentric analysts emphasis on relative gains in a world of competitive states arise from their very different assumptions Economists and Public Policy The prominent role of professional economists in American public life has been an important feature of American society since the end of World War II In 1946 the Full Employment Act assigned the im portant task of ensuring full employment to the federal government the Council of Economic Advisors whose members have included some of Americas most distinguished economists was created by that Act to assist the President and the federal government to carry out this responsibility Gradual acceptance within the economics pro fession of the Keynesian doctrine of demand management provided the Council with the rationale and tools for macromanagement of the American economy Celebrating the elevated status of the economist in American public affairs Walter Heller chairman at that time of President Lyndon 37 This term is named after Vilfredo Pareto 18481923 an Italian economist and sociologist 38 A Paretooptimum equilibrium is one in which at least one individuals welfare would be improved and no other individuals welfare would be lessened 69 C H A P T E R T H R E E Johnsons Council of Economic Advisors proclaimed in his 1965 Godkin Lectures at Harvard University the arrival of the age of the economist 39 The theoretical triumph of Keynesian economics Heller told his audience meant that economists now knew how to fine tune the economy in order to avoid the twin perils of recession and inflation at long last the destructive business cycle had been conquered Moreover he added the American political elite had ac cepted Keynesian macroeconomics Even President Richard Nixon agreed a few years later that we are all Keynesians now Heller pointed out that as a consequence economists now sat at the right hand of the President and advised the President on how to guide the economy to everincreasing prosperity A few years later Harry John son an economist of a much more conservative inclination pro claimed that the ability of economists to quantify and predict consti tuted their claim to superiority over most intelligent individuals with an interest in economic problems 40 These statements by Heller and Johnson reflected economists con fidence in the efficacy of their methods and theories in the early dec ades after World War II Unfortunately economists frequently have been overly confident in their methods believing that if something cannot be measured quantified or tested by the methods of econom ics it either does not exist or at least is irrelevant economists have often excluded other analytic approaches The economics profession often ignores crucial aspects of social reality that cannot be modeled or made consistent with neoclassical assumptions Kenneth Arrow one of the truly great minds of modern economics has suggested a plausible explanation for this excessive selfconfidence Economists Arrow points out see themselves as privileged purveyors of rational ity certainly the intellectual confusion and imprecise thinking en countered in public debate on economic issues lends credence to such a selfperception Yet as Arrow continues Unfortunately there is a close connection between rationality and intolerance If you know a thing a priori the way you know a column of figures is right when it is correctly calculated there is no room for argument and anyone who disagrees must be either stupid or dishonest 41 39 Walter W Heller New Dimensions of Political Economy Cambridge Harvard University Press 1966 40 Harry G Johnson On Economics and Society Chicago University of Chicago Press 1975 41 Kenneth Arrow quoted in E L Jones Economics in the History Mirror Eco nomic Discussion Papers No 688 School of Business La Trobe University Bundoora Victoria Australia 78 70 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y The predilection among economists to ignore those social and po litical aspects of public affairs that cannot be modeled means that economists generally analyze public problems or make policy pro nouncements as if the fundamental issues at stake were solely or at least primarily economic Of course experts in many other fields have similar predilections The knowledge expertise of experts is frequently more limited than they are willing to admit to themselves or to anyone else In this way economists and other experts exhibit a trainedincapacity 42 Robert Keohane in his incisive critique of the McCracken Report has demonstrated superbly the tendency of econ omists to disregard the opinions of experts in other fields to be to tally unaware of the politicalideological biases inherent in their own policy recommendations and to go beyond their competence when advising governments 43 During the early decades following World War II the world econ omy experienced rapid economic growth and relatively low rates of inflation In the early 1970s this happy situation suddenly turned sour During the previous decade particularly after escalation of the Vietnam War the rate of inflation had accelerated and this began to dampen the rate of growth Other developments including a slow down in the rate of growth in productivity in the United States and in Europe had contributed to growing problems in the world econ omy In 1973 the crisis caused by a sudden large increase in the price of oil changed matters dramatically and plunged the world economy into stagflation an unprecedented combination of low economic growth rising unemployment and severe inflation Much to their embarrassment economists had to admit that at this time they knew neither how to finetune the economy nor how to avoid the scourge of the business cycle Trying to find out what had gone wrong the Organization of Economic Cooperation and Development OECD in Paris appointed a commission of eight eminent economists from advanced capitalist economies led by chairman Paul McCracken to study the situation The commission was asked to prepare a report on the main policy issues involved in the pursuit by member coun tries of noninflationary economic growth and high employment lev els in the light of the structural changes which have taken place in the recent past After eighteen months of work the OECD Secretariat 42 This thesis is elaborated in my book American Scientists and Nuclear Weapons Policy Princeton Princeton University Press 1962 43 Robert O Keohane Economics Inflation and the Role of the State Political Implications of the McCracken Report World Politics 31 no 1 October 1978 10828 71 C H A P T E R T H R E E published the commissions report entitled Towards Full Employ ment and Price Stability 1977 The thesis of the report was that the economic troubles of the 1970s had been caused primarily by certain policy errors of OECD member governments errors that included overexpansionary eco nomic policies and failure to respond properly to the inflationary con sequences of the breakdown of the system of fixed exchange rates Although presented as economic truth the reports analysis was actu ally based on a politically conservative marketoriented ideology As Keohane writes Pervading the report is the view that contemporary democratic governments are unwilling to exercise sufficient domestic discipline particularly monetary discipline 44 Governments the re port suggests had been too lax and had given in to the temptation of easy monetary policies in order to win favor with their electorates The solution offered by the report was reimposition of economic dis cipline and limitation of the publics economic aspirations The re ports idea that a disciplinary rather than a welfare state was needed to make capitalism work was adopted by economic conserva tives and put into practice by President Ronald Reagan and Prime Minister Margaret Thatcher in the 1980s Although the McCracken Report concluded that the causes of the economic disarray of the 1970s were located in the realms of social and political affairs none of the economists on the committee were experts in those areas As Keohane pointed out the fundamental issue confronting the McCracken committee was the conflict or at least the apparent conflict between the necessary conditions for modern economic growth and the nature of both modern democracy and the welfare state Yet the economistauthors of the report Keohane sug gests appear to have been totally unaware that they were dealing with a classic conflict between capitalism and democracy Nor did they make any attempt to judge the political feasibility of their recom mendations for resolving this fundamental clash In Keohanes words A more profound understanding of macroeconomic events will only be achieved by combining the economic argument with the analysis of conflicts of interests and the exercise of power as they take place within different national societies and the international political economy 45 Economists neglect of the social and political dimensions of public affairs and public policy originates in their tendency to treat economic 44 Ibid 11112 45 Ibid 116 72 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y issues as if they were solely or at least primarily technical problems Because economists believe that reality consists of only those matters that they can model and quantify even when they are aware of the role of social factors or political forces that shape economic and pub lic affairs they deem such matters to be outside the scope of econom ics and therefore irrelevant because they cannot be measured or mod eled Therefore economists deliberately ignore or downgrade such factors in their analyses and policy recommendations Whereas econ omists believe that economics is scientific they frequently regard so cial and political affairs as matters of personal taste and private opinion Nonetheless as Paul Krugmans popular writings have indicated economists confidence in their ability to guide the economy and to advance the commonweal had significantly weakened after Hellers 1965 Godkin Lectures mentioned earlier The discovery of the natu ral rate of unemployment and development of the theory of rational expectations revealed the limitations of economists macroeconomic policy tools 46 Moreover Krugman bemoaned the fact that policy entrepreneurs frequently displaced economists in providing eco nomic advice to society Referring to supplyside economics and other questionable economic doctrines Krugman using less than elegant words suggested that a major task for economists must be to flush such economic cockroaches down the toilet 47 As I discuss both the strengths and limitations of economics I note that the strengths generally outweigh the weaknesses With the rigor of their methods and the insights of their theories economists have made major contributions to public affairs and have tried not always with success to safeguard the public against such a dubious idea as trade protectionism and against the excesses of economic regionalism The economics profession itself however is deeply divided on such issues as trade monetary affairs and economic development even though the problems of the global economy and possible solutions are often treated by economists as if they were solely technical matters amenable to the methods of economic science Although the contribu tions of economics have been crucial to our understanding of the world economy one must also appreciate the role of political and 46 In nontechnical terms the natural rate of unemployment is the lowest rate that an economy can sustain without experiencing inflation The doctrine of rational expecta tions posits that the market will always anticipate government policy and will neutral ize its intended effects 47 Paul R Krugman Peddling Prosperity Economic Sense and Nonsense in the Age of Diminished Expectations New York W W Norton 1994 29192 73 C H A P T E R T H R E E other factors in determining the nature and dynamics of the world economy Comparison of Economics and Political Economy Economics is clearly a more rigorous and theoretically advanced field of study than are political economy and the other social sciences However economics is based on highly restrictive methodological as sumptions and despite flourishing economic imperialism the do main of formal economic analysis is quite limited Moreover efforts to apply the rational choice techniques of economic analysis to the messy world of politics and social affairs more generally have not achieved consistent success Although economic theories and methods are important and provide an essential foundation for the study of political economy they are not in themselves sufficient to explain the nature and dynamics of the real world economy This writer be lieves that combining the insights and theories of economics with the more intuitive and less rigorous techniques of history and the other social sciences leads to a more profound and useful comprehension of economic affairs than does adherence to any one field alone The most fundamental difference between neoclassical economics and the study of political economy is in the nature of the questions asked and of the answers given Neither is superior to the other nor is there any necessary conflict between the answers given by neoclassical economists to the questions that interest them and the answers given by political economists to their different questions The two subjects complement one another and political economists of almost every persuasion do in fact accept most or at least much of the corpus of conventional neoclassical economics Even though political econo mists frequently consider the theories of neoclassical economics to be too limited too abstract and in many cases not directly relevant to the particular questions of interest to them insofar as they are techni cally competent to do so they draw upon the accepted theories of economics as they study many specific issues Economics and political economy differ significantly in their view of the role of the market in economic affairs and of the relationship of the market to other aspects of society Whereas neoclassical econo mists believe that the market is autonomous selfregulating and gov erned by its own laws almost all political economists assume that markets are embedded in larger sociopolitical structures that deter mine to a considerable extent the role and functioning of markets in social and political affairs and that the social political and cultural 74 N E O C L A S S I C A L C O N C E P T O F A N E C O N O M Y environment significantly influences the purpose of economic activi ties and determines the boundaries within which markets necessarily must function 48 Neoclassical economists and scholars of political economy also dis agree with one another regarding the limitations of economics as an analytic tool useful for understanding the dynamics of social politi cal and even economic affairs While economic science provides a useful framework for static analysis it seldom can explain changes in fundamental economic variables for example despite the central role of technological developments in economic affairs economists do not have an explanation for technological change In fact the crucial de terminants of economic change lie outside the framework of eco nomic analysis Reviewing the economics literature on the subject of economic change Joseph Stiglitz comes to the astonishing conclusion that economists have not learned much about the dynamics of the economy 49 Despite the attempts of economic imperialists and rationalchoice theorists to explain all forms of human behavior through application of the techniques of microeconomics these techniques have limited utility for analyzing and explaining human behavior Most political economists I believe would agree with the distinguished economist Joseph Schumpeter that economic analysis progresses until it inevita bly encounters social political and psychological factors that eco nomics cannot explain 50 Although the research strategy of economic science is to endogenize exogenous variables economic analysis and explanation are unlikely ever to exceed a certain limit 51 There will always be exogenous variables such as culture technology and institutions that affect economic outcomes but cannot themselves be 48 The concept of embeddedness is taken from the literature on economic sociol ogy An excellent discussion of this field of scholarship is Neil J Smelser and Richard Swedberg eds The Handbook of Economic Sociology Princeton Princeton Univer sity Press 1994 While this field of scholarship has produced classic works by Max Weber Talcott Parsons and others economic sociology with the major exception of radical sociology has not devoted much attention to the international economy 49 Joseph E Stiglitz Another Century of Economic Science Economic Journal 101 January 1991 139 50 Joseph A Schumpeter The Theory of Economic Development An Inquiry into Profits Capital Credit Interest and the Business Cycle Cambridge Harvard Univer sity Press 1934 45 I am indebted to Robert Keohane for bringing Schumpeters comments to my attention 51 To endogenize an exogenous variable such as the behavior of a politician means that the exogenous variable can be explained by the logic of economics individuals rationally seek to increase their own interests This assumption is of course the basis of the publicchoice school 75 C H A P T E R T H R E E explained endogenously by the methods of economics that is in terms of rational individuals attempting to maximize their economic selfinterest As Schumpeter states in another context conventional economics can tell us how to manipulate the existing economic apparatus in order to increase its efficiency but economics cannot explain how that economic apparatus came into existence in the first place 52 Yet identifying the determinants of an economic system is one of the most important problems that should be solved by economists and political economists alike Indeed how can economic development be under stood without an answer to this question Conclusion The analytic techniques rich empirical data and theoretical insights of neoclassical economics are essential ingredients in the study of po litical economy in general and international political economy in par ticular Nevertheless it is important to keep in mind the fact that economic activities occur within differing sociopolitical structures and that these structures greatly influence their outcomes Under standing of the international economy must therefore be based on the contributions of international political economics as well as on economics itself 52 Joseph A Schumpeter Capitalism Socialism and Democracy New York Harper and Brothers 1947 76 CHAPTER FOUR The Study of International Political Economy T HE STUDY of international political economy IPE is of necessity highly dependent on the theories and insights of neoclassical eco nomics However IPE and neoclassical economics ask different ques tions as they apply their own mode of analysis 1 Whereas economics is primarily concerned with efficiency and the mutual benefits of eco nomic exchange international political economy is interested not only in those subjects but also in a broader range of issues IPE is particularly interested in the distribution of gains from market activi ties neoclassical economics is not Although at least over the long term every society gains absolutely from the efficient functioning of international markets the gains are seldom distributed equally among all economic actors and states generally are very much concerned over their own relative gains Whereas economists regard markets as selfregulating mechanisms isolated from political affairs specialists in IPE are interested in the fact that the world economy has a consid erable impact on the power values and political autonomy of na tional societies States have a strong incentive to take actions that safeguard their own values and interests especially their power and freedom of action and they also attempt to manipulate market forces to increase their power and influence over rival states or to favor friendly states 2 Whereas economists and economic analysts are generally indiffer ent to the role of institutions in economic affairs due to their focus on the market the nature of the international institutions and those international regimes that govern international markets and economic activities constitute a central concern of international political econo mists As regimes may significantly affect the distribution of gains from economic activities and the economicpolitical autonomy of in 1 An excellent history of IPE albeit too focused on American contributions is Peter Katzenstein Robert O Keohane and Stephen D Krasner International Organization and the Study of World Politics in Peter Katzenstein Robert O Keohane and Ste phen D Krasner International Organization at Fifty Exploration and Contestation in the Study of World Politics International Organization 52 no 4 autumn 1998 2 Joanne Gowa Allies Adversaries and International Trade Princeton Princeton University Press 1994 77 C H A P T E R F O U R dividual states statesespecially powerful statesattempt to influ ence the design and functioning of institutions in order to advance their own political economic and other interests Thus the study of international political economy presumes that states multinational corporations and other powerful actors attempt to use their power to influence the nature of international regimes 3 Distribution of Wealth and Economic Activities Whereas the science of economics emphasizes the efficient allocation of scarce resources and the absolute gains enjoyed by everyone from economic activities statecentric scholars of international political economy emphasize the distributive consequences of economic activi ties According to economics exchange takes place because of mutual gain were it otherwise the exchange would not occur IPEs state centric interpretation on the other hand argues that economic actors are attentive not only to absolute but also to relative gains from eco nomic intercourse that is not merely to the absolute gain for them selves but also to the size of their own gain relative to gains of other actors Governments are concerned about the terms of trade the dis tribution of economic returns from foreign investment and in partic ular the relative rates of economic growth among national econo mies Indeed the issue of relative gains is seldom far from the minds of political leaders The significance of relative gains for economic behavior and in the calculations of nationstates was recognized at least as early as the economic writings of the eighteenthcentury political philosopher Da vid Hume 17111776 Humes mercantilist contemporaries argued that a nation should seek a trade and payments surplus basing their arguments on the assumption that it was only relative gains that re ally mattered In todays language of game theory international com merce during the mercantilist era was considered to be a zerosum game in which the gain to one party necessarily meant a loss to an other Hume himself demonstrated the folly and selfdefeating nature of this mercantilist argument by introducing the pricespecie flow mechanism into economic thought 4 Subsequently formulation by 3 Stephen D Krasner ed International Regimes Ithaca Cornell University Press 1983 4 In oversimplified terms the pricespecie flow mechanism states that the flow of specie gold or silver into an economy as a consequence of a tradepayments surplus increases the domestic money supply and raises prices of a countrys exports This price rise in turn decreases the countrys tradepayments surplus In short any attempt to have a permanent tradepayments surplus is selfdefeating See David Hume in Eugene Rotwein ed Writings on Economics London Nelson 1955 78 I N T E R N A T I O N A L P O L I T I C A L E C O N O M Y David Ricardo 17721823 of the law or principle of comparative advantage revealed that every nation could gain in absolute terms from free trade and from an international division of labor based on territorial specialization Subsequent modifications of Ricardos the ory suggested that states were also interested in the relative gains from trade Ricardos demonstration that international economic ex change was not a zerosum game but rather a positivesum game from which everyone could gain led Paul Samuelson to call the law of com parative advantage the most beautiful idea in economic science However both absolute gains and the distribution of those gains are important in international economic affairs A number of political economists have addressed the issue of abso lute versus relative gains in international affairs and the ensuing de bate has largely centered on Joseph Griecos argument that states are more concerned about relative than absolute gains and that this cre ates difficulties in attaining international cooperation 5 Although I know of no political economist who dismisses altogether the role of relative gains in international economic affairs scholars of IPE do differ on the weight each gives to relative versus absolute gains Whereas many scholars stress the importance of relative gains liber als emphasize the importance of absolute gains and believe that Grieco has overstated the significance of relative gains Absolute gains they argue are more important than Griecos analysis suggests and therefore international cooperation should be easier to attain than he postulates While Griecos emphasis on the importance of relative gains is I believe basically important and states do in gen eral prize relative gains sometimes even at the expense of absolute gains this argument cannot be elevated into a general law of state behavior 6 One can say about this generalization in political economy no more than Kindleberger has said of most generalizations in eco nomics It depends The importance of absolute versus relative gains in state calcula tions is actually highly dependent upon the circumstances in which a specific tradeoff occurs While it may be true that states can never be 5 Joseph M Grieco Cooperation Among Nations Europe America and NonTariff Barriers to Trade Ithaca Cornell University Press 1990 An excellent volume on the debate over the importance of relative versus absolute gains is David A Baldwin ed Neorealism and Neoliberalsim The Contemporary Debate New York Columbia Uni versity Press 1993 6 This point is also made in Robert Powell The Shadow of Power States and Strate gies in International Politics Princeton Princeton University Press 1999 80 Also Michael MastandunoDo Relative Gains Matter Americas Response to Japanese In dustrial Policy International Security 16 no 1 summer 1991 73113 79 C H A P T E R F O U R totally unconcerned about the distributive consequences of economic activities for their relative wealth and power they frequently do largely for security reasons ignore this concern in their dealings with others During the height of the Cold War for example the United States fostered the economic unification of Western Europe for politi cal reasons despite the costs to its own economic interests Kenneth Waltz has noted that the conscious decision of the United States in the late 1940s to build the power of its European allies at a sacrifice to itself was a historically unprecedented action 7 States are particularly interested in the distribution of those gains affecting domestic welfare national wealth and military power When a state weighs absolute versus relative gains military power is by far the most important consideration states are extraordinarily reluctant for example to trade military security for economic gains Modern nationstates like eighteenthcentury mercantilists are ex tremely concerned about the consequences of international economic activities for the distribution of economic gains Over time the un equal distribution of these gains will inevitably change the interna tional balance of economic and military power and will thus affect national security For this reason states have always been very sensi tive to the effects of the international economy on relative rates of economic growth At the beginning of the twentyfirst century con cern is focused on the distribution of industrial power especially in those hightech industries vitally important to the relative power posi tion of individual states The territorial distribution of industry and of technological capabilities is a matter of great concern for every state and a major issue in international political economy National Autonomy One of the dominant themes in the study of international political economy IPE is the persistent clash between the increasing interde pendence of the international economy and the desire of individual states to maintain their economic independence and political auton omy At the same time that states want the benefits of free trade foreign investment and the like they also desire to protect their polit ical autonomy cultural values and social structures However the logic of the market system is to expand geographically and to incor porate more and more aspects of a society within the price mecha nism thus making domestic matters subject to forces external to the 7 Kenneth Waltz Theory of International Politics Reading Mass AddisonWesley 1979 80 I N T E R N A T I O N A L P O L I T I C A L E C O N O M Y society In time if unchecked the integration of an economy into the world economy the intensifying pressures of foreign competition and the necessity to be efficient in order to survive economically could undermine the independence of a society and force it to adopt new values and forms of social organization Fear that economic global ization and the integration of national markets are destroying or could destroy the political economic and cultural autonomy of na tional societies has become widespread The clash between the evolving economic and technical interdepen dence of national societies and the continuing compartmentalization of the world political system into sovereign independent states is one of the dominant motifs of contemporary writings on IPE Whereas powerful market forces trade finance and investment jump political boundaries and integrate societies governments frequently restrict and channel their economic activities to serve the interests of their own societies and of powerful groups within those societies Whereas the logic of the market is to locate economic activities wherever they will be most efficient and profitable the logic of the state is to capture and control the process of economic growth and capital accumulation in order to increase the power and economic welfare of the nation The inevitable clash between the logic of the market and the logic of the state is central to the study of international political economy Most economists and many political economists believe that the international economy has a positive impact on international political affairs The international economy many argue creates webs of mu tual interdependence and common interests that moderate the self centered behavior of states Underlying this benign interpretation is a particular definition of economic interdependence as dependence However as Albert Hirschman pointed out in National Power and the Structure of Foreign Trade 1969 while economic interdepen dence may be characterized by mutual dependence dependence is fre quently not symmetrical 8 Trade investment and markets establish dependencies among national societies that can be and are exploited Integration of national markets creates power relations among states where as Hirschman notes economic power arises from the capacity to interrupt economic relations 9 Economic ties among states almost always involve power relations Robert Keohane and Joseph Nye 1977 extended this analysis of economic power and the political aspects of economic interdepen 8 Albert O Hirschman National Power and the Structure of Foreign Trade Berke ley University of California Press 1969 9 Ibid 16 81 C H A P T E R F O U R dence by distinguishing sensitivity interdependence from vulnera bility interdependence Most economists really are referring to sensi tivity interdependence exemplified by responsiveness among economic variables such as changes in interest rates in one country that influence interest rates in another Vulnerability interdependence on the other hand is what Hirschman and political economists frequently have in mind when they speak of economic interdependence this latter term refers to the possibilities of political exploitation of market interdepen dencies 10 Individual states have a powerful incentive either to decrease their own dependence on other states through such policies as trade protection and industrial policies or to increase the dependence of other states upon them through such policies as foreign aid and trade concessions International economic relations are never purely eco nomic they always have profound implications for the economic au tonomy and political independence of national societies The Politics of International Regimes All economists and political economists acknowledge the need for some minimal rules or institutions to govern and regulate economic activities even the most ardent publicchoice economist would agree that laws are needed to enforce contracts and protect property rights A liberal international economythat is an international economy characterized at least in ideal terms by such factors as open markets freedom of capital movement and nondiscriminationcertainly needs agreedupon rules A liberal economy can succeed only if it provides public goods like a stable monetary system eliminates mar ket failures and prevents cheating and freeriding 11 Although the pri mary purpose of rules or regimes is to resolve economic problems many are actually enacted for political rather than for strictly eco nomic reasons For example although economists may be correct that an economy benefits from opening itself to free trade whether or not other countries open their own markets to it a liberal international economy could not politically tolerate too many freeriders who bene fit from the opening of other economies but refuse to open their own markets 10 Robert O Keohane and Joseph S Nye Jr Power and Interdependence World Politics in Transition Boston Little Brown 1977 11 In nontechnical language a public or collective good is one that everyone can enjoy without having to pay for the use of the good A frequently used example is a lighthouse Because of this free use no one usually has an incentive to provide them and therefore public goods tend to be underprovided The literature on this subject and on proposed solutions to the underprovision problem is extensive 82 I N T E R N A T I O N A L P O L I T I C A L E C O N O M Y In the past the rules governing the international economy were quite simple and informal Insofar as the implicit rules were enforced at all they were enforced by the major powers whose interests were favored by those rules For example in the nineteenth century under the Pax Britannica overseas property rights were frequently upheld by British gunboat diplomacy 12 and the international gold stan dard based on a few generally accepted rules was managed by the Bank of England Now formal international institutions have been created to manage todays extraordinarily complex international economy The most important institutions are the Bretton Woods in stitutions such as the World Bank the International Monetary Fund and the World Trade Organization The world economy would have difficulty functioning without these institutions Therefore under standing their functioning has become an extremely important con cern of political economists 13 The concept of international regimes defined as sets of implicit or explicit principles norms rules and decisionmaking procedures around which actors expectations converge in a given area of inter national relations has been at the core of the research on interna tional institutions 14 Although a distinction can be made between an international regime as rules and understandings and an international institution as a formal organization the word regimes and the word institutions are frequently used interchangeably in writings on international political economy Moreover what is really impor tant for the functioning of the world economy are the rules them selves rather than the formal institutions in which they are usually embodied To simplify the following discussion I shall use interna tional regime to encompass both rules and such formal international organizations as the International Monetary Fund or the General Agreement on Tariffs and Trade 12 Charles Lipson Standing Guard Protecting Foreign Capital in the Nineteenth and Twentieth Centuries Berkeley University of California Press 1985 13 Many realists would disagree with my belief that international organizations are important at least in the area of economic affairs and insofar as they do not infringe on the security interests of powerful states 14 Stephen Krasner Structural Causes and Regime Consequences Regimes as Inter vening Variables International Organization 36 no 2 spring 1982 186 As Krasner himself points out there are several variants of regime theory For this reason I shall focus on what I consider to be the common denominators in these theories Richard N Cooper coined the term international regime in his Prolegomena to the Choice of an International Monetary System International Organization 29 no 1 winter 1975 64 The term regime was introduced into the IPE literature by John Ruggie International Responses to Technology Concepts and Trends International Organization 29 no 3 summer 1975 570 83 C H A P T E R F O U R Robert Keohane has been the most influential scholar in the devel opment of regime theory In his book After Hegemony 1984 Keo hane set forth the definitive exposition and classic defense of regime theory 15 He argues that international regimes are a necessary feature of the world economy and are required to facilitate efficient operation of the international economy Among the tasks performed by regimes are reduction of uncertainty minimization of transaction costs and prevention of market failures International regimes are created by selfcentered states in order to further both individual and collective interests Even though a particular regime might be created because of the pressures of a dominant power or hegemon Keohane argues that an effective international regime takes on a life of its own over time Moreover when states experience the success of an interna tional regime they learn to change their own behavior and even to redefine their national interests Thus according to Keohanes analy sis international regimes are necessary to preserve and stabilize the international economy From its beginning regime theory has been surrounded by intense controversy One major reason for the intensity of this debate is that regime theory arose as a response to what Keohane labeled the the ory of hegemonic stability 16 Proponents of the latter theory had ar gued that the postwar liberal international economy was based on the economic and political leadership of the United States Some theorists had argued that the hegemonic stability theory also suggested that the relative decline of American power due to the rise of new economic powers and the slowing of American productivity growth in the early 1970s placed the continued existence of a liberal world economy in jeopardy As Steven Weber has pointed out regime theory was largely a response to the perceived decline of American power the 1973 en ergy price shock and the global stagflation of the 1970s 17 Keohane and others argued that international regimes and cooperation among 15 Robert O Keohane After Hegemony Cooperation and Discord in the World Po litical Economy Princeton Princeton University Press 1984 16 Robert O Keohane The Theory of Hegemonic Stability and Changes in Interna tional Economic Regimes 19671977 in Ole Holsti et al Change in the Interna tional System Boulder Colo Westview Press 1980 13162 17 Steven Weber Institutions and Change in Michael Doyle and John Ikenberry eds New Thinking in International Relations Boulder Colo Westview Press 1997 The emphasis on regimes also grew out of the realization in the 1970s that interna tional governance was not codeterminous with international organizations Consult Friedrich Kratochwil and John Gerard Ruggie International Organization A State of the Art on an Art of the State International Organization 40 no 4 autumn 1986 75375 84 I N T E R N A T I O N A L P O L I T I C A L E C O N O M Y the major economic powers would replace declining American leader ship as the basis of the liberal international economic order Thus the political purpose of regime theory was at least in part to reassure Americans and others that a liberal international order would survive Americas economic decline and the severe economic problems of the 1970s British scholar Susan Strange was the most outspoken critic of re gime theory 18 According to Strange regime theory was at best a pass ing fad and at worst a polemical device designed to legitimate Ameri cas continuing domination of the world economy Strange and other critics alleged that such international regimes as those governing trade and monetary affairs had been economically politically and ideologi cally biased in Americas favor and that these regimes were put in place by American power reflected American interests and were not as American regime theorists have argued politically and economi cally neutral Strange charged that many of the fundamental problems afflicting the world economy actually resulted from illconceived and predatory American economic policies rather than simply being symptoms of American economic decline Stranges foremost example of American culpability was the huge American demand in the 1980s and 1990s for international capital to finance Americas federal budget and tradepayments deficit 19 Through use of what she referred to as structural power such as Americas military financial and technological power she alleged that the United States continued to run the world economy during that period and made a mess of it Strange and other critics also al leged that the role of the dollar as the key international currency had permitted the United States to behave irresponsibly More generally Strange and other foreign critics charged that the American discipline of international political economy and regime theory in particular have been little more than efforts to defend Americas continuing de sire to reign economically and politically over the rest of the world Whether or not we accept these criticisms they should remind us that regimes and other social institutions are sometimes created to pre serve inequalities as well as to improve coordination and overcome 18 Susan Strange Cave hic Dragones A Critique of Regime Analysis in Stephen D Krasner ed International Regimes 33754 It is noteworthy that very few non American scholars have been positively inclined toward regime theory or involved in its development A major exception is Volker Rittberger ed Regime Theory and Inter national Relations New York Oxford University Press 1993 19 Susan Strange Casino Capitalism New York Basil Blackwell 1986 and Susan Strange Mad Money Manchester UK Manchester University Press 1998 85 C H A P T E R F O U R other obstacles to mutually beneficial cooperation 20 It is desirable to study such important issues as the origins of international regimes the content rules and norms of international regimes and the history of compliance by affected states particularly in situations when a regime is perceived as being counter to a states interests Origins International regimes have developed in a number of different ways Some have arisen spontaneously and do not involve conscious design many of the informal rules governing markets are of this type Others have resulted from international negotiations among states the post World War II Bretton Woods system of trade and monetary regimes for example was the result of international negotiations primarily between the United States and Great Britain Still other regimes have been imposed by powerful states on less powerful ones the colonial systems of the nineteenth century are a notorious example This sec tion will concentrate upon regimes created through international ne gotiations especially the Bretton Woods regimes for trade and mone tary affairs that were the result of American leadership In creating the postWorld War II regimes the most important task for American leadership was to promote international coopera tion The United States undertook the leadership role and other eco nomic powers Canada Japan and Western Europe cooperated for economic political and ideological reasons These allies believed that a liberal world economy would meet their economic interests and also solidify their alliance against the Soviet threat In addition coopera tion was greatly facilitated by the fact that these nations shared an ideological commitment to a liberal international economy based on free trade and open markets 21 All three factorsleadership coopera tion and ideological consensuswere important to creation of the postWorld War II liberal international economy 20 Andrew Schotter The Economic Theory of Social Institutions New York Cam bridge University Press 1981 26 21 The term epistemic community attributed to John Ruggie has been given to the role of shared ideas or beliefs in promoting international cooperation A useful discussion is Peter Haas Saving the Mediterranean New York Columbia University Press 1990 An important volume on the subject is Judith Goldstein and Robert O Keohane eds Ideas and Foreign Policy Beliefs Institutions and Political Change Ithaca Cornell University Press 1993 Another important study is Judith Goldstein Ideas Interests and American Trade Policy Ithaca Cornell University Press 1993 While I agree that ideas are very important they are important politically insofar as they are supported by the interests and power of important actors such as states or domestic political coalitions 86 I N T E R N A T I O N A L P O L I T I C A L E C O N O M Y Content The content of an international regimethe precise rules and deci sionmaking techniques embodied in a particular regimeis deter mined by technological economic and political factors An interna tional regime could not function well if its rules were counter to scientific and technological considerations Regimes governing inter national economic affairs must be based on sound economic princi ples and must be able to solve complex economic matters The post war international monetary regime based on fixed exchange rates for example had to solve such difficult technical problems as provision of international liquidity and creation of an adjustment mechanism for nations with balance of payments problems Economists however seldom agree on such complex issues there are for example several competing theories on the determination of exchange rates It is important to realize that the specific means cho sen to solve a given economic problem may have significant conse quences for individual states andor may impinge on their national autonomy In the early postwar monetary system the central role of the US dollar as a reserve and transaction currency greatly facilitated financing of American foreign policy Thus while the content of an international regime must be grounded on sound technical and eco nomic considerations it is important to recognize that regimes do produce political effects A number of regime theorists have a tendency to think of regimes as benign Regime theory has emphasized the efficiency and efficacy of international cooperation and problemsolving and that regimes are instituted to achieve interstate cooperation and information shar ing to reduce transaction costs and to solve common problems While these goals do exist it is also true as some scholars of institu tions point out that institutionsand regimesdo create or preserve inequalities regimes can also have a redistributive function 22 History is replete with such examples as the carvingup of Africa at the Con gress of Berlin 1878 and the postWorld War I mandate system The purpose content and actual consequences of every international regime must be closely examined there should be no assumption that regimes are ipso facto of equal or mutual benefit to every participant 22 In his analysis of institutions and by implication regimes Schotter in his book The Economic Theory of Institutions identifies four types of problems whose solutions lead to the creation of institutions coordination problems prisoners dilemmatype games cooperativetype games and most important for my present purpose problems of inequality preservation 87 C H A P T E R F O U R Because international regimes frequently do have distributive con sequences as well as implications for national autonomy the rules norms and other factors embedded in regimes generally reflect the power and interests of the dominant powers in the international sys tem Certainly the liberal trade and monetary regimes following World War II promoted the economic and I would emphasize the political and security interests of the United States while also strength ening the antiSoviet political alliance Moreover as American inter ests changed the United States used its power to modify one or an other of these regimes the August 1971 Nixon decision to destroy the system of fixed exchange rates because he believed that it no longer suited American interests provided a particularly striking ex ample of this type of behavior Nevertheless it is unlikely that the regimes governing a liberal in ternational economy do or will represent the interests of the dominant powers alone and of no others Liberal international regimes must satisfy the interests of all the major economic powers to at least some degree if they do not the regimes would neither function nor long survive The major trading partners of the United States were satisfied with the postwar trade regime and in fact benefited economically from the regime more than did the United States Although a liberal international economic order does reflect the interests of a dominant power such a power cannot impose a liberal economic order on the rest of the world ultimately the regime must rest on international cooperation Compliance Although some scholars deny or at least minimize the importance of the compliance issue compliance with international regimes is a ma jor problem and it is important to understand the reasons for compli ance or noncompliance 23 The compliance or enforcement problem arises because there is no authoritative international government be cause states frequently value highly their relative gains and national autonomy and because there is a collective action problem in which individual actors are tempted to cheat and free ride While the com pliance problem may be of minor significance in many or even the majority of international regimes when the rules and principles of 23 Some scholars for example argue that as most states do comply with international regimes compliance is not a serious problem This position that George W Downs David M Rocke and Peter N Barsoom label the managerial school is criticized by these authors in their Is the Good News About Compliance Good News About Cooperation International Organization 50 no 3 summer 1996 379406 88 I N T E R N A T I O N A L P O L I T I C A L E C O N O M Y an international regime have significant distributive consequences for states and powerful domestic groups or when they impinge signifi cantly on the autonomy and security of states the compliance prob lem becomes of overwhelming importance Many of the international regimes governing the world economy in fact are of this latter type because they do have important consequences for the distribution of global wealth and national autonomy 24 Scholars of international political economy have devoted consider able attention to possible solutions to this problem An important proposed solution is based on the theory of iterative or repeated games and in particular on what game theorists call the Prisoners Dilemma Another is based on insights from the new institutionalism or new economics of organization 25 These approaches fall within the larger category of theories of international cooperation Most scholars of international political economy would accept the defini tion made popular by Robert Keohane that cooperation occurs when actors adjust their behavior to the actual or anticipated prefer ences of others through a process of policy coordination 26 Al though theories of cooperation may be helpful in explicating the na ture and difficulties of the compliance problem they do not really solve the problem The Prisoners Dilemma is undoubtedly familiar to most readers of this book Nevertheless I shall provide a brief reminder Two prison 24 The reasons why the distribution issue is such a major obstacle to international cooperation are discussed by James D Morrow Modeling the Forms of International Cooperation Distribution Versus Information International Organization 48 no 3 summer 1994 387423 The formal treatment by Morrow and others of the distribu tive aspects of international cooperation have not been adequately integrated into the regime literature I am indebted to George Downs for enlightening me on this scholar ship 25 The new institutionalism is based largely on the research of Oliver Williamson and on the concept of transaction costs that is the costs of doing business For a discussion of the relevance of this literature for IPE consult Beth V Yarbrough and Robert M Yarbrough International Institutions and the New Economics of Organi zation International Organization 44 no 2 spring 1990 23559 These ideas have been elaborated in their book Cooperation and Governance in International Trade The Strategic Organizational Approach Princeton Princeton University Press 1992 26 Keohane After Hegemony 5152 For a useful and extensive analysis of theories of cooperation consult Helen Milner International Theories of Cooperation Among Nations Strengths and Weaknesses World Politics 44 no 3 April 1992 46696 Although the literature on game theory and international cooperation distinguishes among different types of problems such as problems of coordination or of collabora tion I shall use cooperation to refer to all the varieties of international cooperation For a valuable discussion of the issue refer to Lisa L Martin Interests Power and Multilateralism International Organization 46 no 4 autumn 1992 76592 89 C H A P T E R F O U R ers are accused of a crime and held separately If they both confess to the crime of which they are accused they will both be punished If neither confessesthat is if in essence they cooperate with one an otherthey will both be punished but less severely However if only one confesses or defects and the other does not confess the latter will be punished more severely Thus although each has an incentive to cooperate with the other by not confessing each also has an incen tive to confess defect Uncertainty regarding what the other player will do could lead to a less than optimal outcome for both players This type of mixed motive game in which the players have a motive to cooperate and also a motive to defect is characteristic of almost every aspect of international politics and certainly of international economic affairs Although the players would gain from cooperation each might gain even more by defecting cheating yet both would lose if both cheat For example a nation might be able to increase its own relative gains in the international trading regime by exporting to other markets at the same time that it keeps its own markets closed however if others retaliate and close their markets everyone would lose In a monetary regime a nation could increase its international competitiveness by unilaterally devaluing its own currency However if other countries simultaneously devalue their own currencies every one loses Therefore everyone is better off at least in absolute terms as a result of cooperation Yet the possibility of increasing ones own relative gains by cheating or successfully freeriding always pro vides a powerful temptation in international affairs 27 A number of attempts have been made by economists and other scholars to solve the Prisoners Dilemma Proposed solutions entail methods or techniques designed to increase the likelihood that players will cooperate and not cheat they include creation of norms of reci procity making each move in the game less distinct and linking is sues to one another Such techniques attempt to lessen the incentive to cheat in a particular instance so that the players learn how to coop erate 28 The most noteworthy effort to solve the Prisoners Dilemma has been the concept of iterative games developed by Robert Axelrod and others 29 This concept leads to the conclusion that if a game is 27 Bruno S Frey has a valuable analysis of the freerider problem and why interna tional cooperation is so difficult in his International Political Economics Oxford Basil Blackwell 1984 Chapter 7 28 An important discussion of this subject is Kenneth A Oye ed Cooperation under Anarchy Princeton Princeton University Press 1986 224 29 Robert M Axelrod The Evolution of Cooperation New York Basic Books 1984 90 I N T E R N A T I O N A L P O L I T I C A L E C O N O M Y repeated over and over again and a participant pursues a titfortat strategy in which cooperative moves are rewarded and uncooperative moves are punished the participants in the game will learn to trust and cooperate with one another 30 The literature on the theory of repeated or iterative games has be come extensive and has been subjected to intense theoretical criticism and defense Although scrutiny of the theory has vastly increased our understanding of the compliance problem this scholarly debate has not yet enabled us to predict when cooperation or defection from cheating a regime will in fact occur The fundamental problem of uncertainty and hence of regime compliance has not yet been solved and probably never will be a player can never be absolutely sure whether another player will cooperate or defect and the costs of mis calculation could be extremely high The absence of an adequate body of research on the actual functioning of specific regimes makes it im possible to be confident that regimes are of decisive importance in the behavior of states In addition a fundamental methodological prob lem makes it difficult to determine whether or not regimes actually make a difference in the conduct of international affairs As one strong supporter of regime theory has stated Investigating the con sequences of international regimes requires a counterfactual argu ment that is knowledge of what would happen if the regime did not exist 31 The new economics of organization or what some scholars pre fer to label neoinstitutionalism has produced another important effort to solve the compliance problem This theory of international cooperation has been described by George Downs and David Rocke as a loose composite of transactioncost economics and noncooper ative game theory 32 According to new institutionalism regimes can provide a solution to such problems as market inefficiencies eco nomic uncertainties and market failures However as Downs and Rocke point out this theory of international cooperation makes only a limited contribution to solution of the compliance problem and 30 Criticisms of Axelrods approach to the cooperation problem include Joanne Gowa Anarchy Egoism and Third Images The Evolution of Cooperation and Inter national Relations International Organization 40 no 1 winter 1986 67186 and David E Spiro The State of Cooperation in Theories of State Cooperation The Evo lution of a Category Mistake Journal of International Affairs 42 no 1 fall 1988 20525 31 Rittberger ed Regime Theory and International Relations 32 George W Downs and David M Rocke Optimal Imperfection Domestic Uncer tainty and Institutions in International Relations Princeton Princeton University Press 1995 19 91 C H A P T E R F O U R compliance with international regimes ultimately rests on the domes tic and I would add the foreign policy interests of individual states Despite its important insights into the functioning of the world economy regime theory frequently sidesteps problems of national au tonomy and interests For example every nation joining an interna tional regime reserves the right to withdraw from the regime if its interests change In addition concerns over national autonomy place severe limits on the types of international regimes that are created Even in the North Atlantic Treaty Organization NATO each mem ber reserves the right not to come to the aid of another alliance mem ber if the other is attacked 33 The increasing importance of social welfare in state behavior has not substantially changed matters although many scholars of interna tional political economy have suggested that it has As James Mayall points out international regimes have resulted in few if any sacri fices of domestic social welfare 34 Despite much talk of international distributive justice for example voluntary sharing by one society of a substantial portion of its wealth with other societies is rare indeed Foreign aid for example has never absorbed more than a small per centage of a nations GDP and with a few notable exceptions such aid has been and is given for national security or economic rather than humanitarian reasons The modern welfare system has actually made states even more attentive to their own economic interests The nationalistic nature of the modern welfare state is well demonstrated by the singular fact that every state severely restricts immigration at least in part to restrict access to its welfare system While international regimes are useful to provide solutions to tech nical economic and other problems associated with the world econ omy they also invariably affect the economic welfare national secu rity and political autonomy of individual states For this reason states frequently attempt to manipulate regimes for their own paro chial economic and political advantage This concept of international regimes as both technical solution and arena of political struggle di verges from that held by many economists and liberal scholars of political economy that regimes are economically and politically neu tral The realist interpretation maintains that international regimes are neither above nor outside the struggle for power and advantage among states Regimes are both a part and an object of a political 33 James Mayall Nationalism and International Society New York Cambridge Uni versity Press 1990 In the case of NATO every member has reserved the right whether or not to declare war if another member of the alliance is attacked 34 Ibid Chapter 6 92 I N T E R N A T I O N A L P O L I T I C A L E C O N O M Y struggle As a consequence if a regime is to be effective and its rules are to be enforced it must also rest on a strong political base Due to the central importance of distribution and autonomy issues to most nations the compliance problem is unlikely to be resolved and re gime rules are unlikely to be enforced unless there is strong interna tional leadership Theory of Hegemonic Stability The theory of hegemonic stability discussed below in both its liberal and its realist versions encountered a critical reception from a num ber of scholars 35 The theory was attacked on theoretical historical and political grounds The theoretical criticisms emphasized the pos sibility of a cooperative solution among nonhegemonic nations to the problems associated with creating and maintaining a liberal interna tional economy 36 Although it may be possible to create a stable lib eral international order through cooperation but without a hegemon this has never happened and with no counterfactual example neither the theory nor its critics can be proved wrong This problem of course is endemic in many areas of the social sciences Some critics of the theory have tested it against latenineteenthcentury experience and found weaknesses in the theory 37 Political criticisms have ranged from denunciations of the theory as a defense of or rationale for American policies to the opposite idea that the theory predicted the absolute decline of the United States No proponent of hegemonic stability theory at least to my knowledge has been motivated to jus tify American behavior to the contrary most were very critical of the 35 Several of the most important criticisms of the theory are John A C Conybeare Public Goods Prisoners Dilemmas and the International Political Economy Inter national Studies Quarterly 28 no 1 March 1984 522 David A Lake Leadership Hegemony and the International Economy Naked Emperor or Tattered Monarch with Potential International Studies Quarterly 37 no 4 December 1993 45989 Duncan Snidel The Limits of Hegemonic Stability Theory International Organiza tion 39 no 4 autumn 1985 579614 and Helen V Milner Interests Institutions and Information Domestic Politics and International Relations Princeton Princeton University Press 1997 2425 36 For example as I acknowledge above the critics may be correct that significant international economic cooperation is possible without a hegemon provided that cer tain conditions exist such as the number of players is small international regimes exist and the shadow of the future is long enough However this solution to the problem of international cooperation has never been tried 37 An example is Timothy J McKeown Hegemonic Stability Theory and 19th Cen tury Tariff Levels in Europe International Organization 37 no 1 winter 1983 7391 93 C H A P T E R F O U R selfcentered and irresponsible American behavior that began in the 1960s if not earlier 38 A major reason for the criticisms of the theory by political scientists is that it was never adequately formulated Indeed the theory was more an intuitive idea based on a particular reading of history than a scientific theory Because the theory was underdeveloped it was open to both warranted and unwarranted criticisms A number of critics for example interpreted the theory to mean that a dominant power is necessary to the emergence of a liberal international econ omy they have gone on to make the point that Soviet hegemony did not create a liberal Sovietdominated international economy How ever as I have emphasized in numerous writings a liberal interna tional economy requires a hegemon committed to liberal economic principles as Great Britain was in the nineteenth century and the United States was in the twentieth century the theory was never in tended to suggest that a Soviet Union Nazi Germany or militaristic Japan would promote a liberal world economy Moreover despite the implied criticisms of some authors the theory at least in my opinion posited that a hegemon is a necessary but not a sufficient condition for establishment of a liberal international economy It is possible as some critics have argued that a hegemons interests would be best served by an optimum tariff yet such an aggressive tactic would be a highly unlikely course of action for a strong liberal power such as Great Britain or the United States Instead the theory rests on the idea of international cooperation Hegemony makes cooperation more feasible and is not as some have suggested opposed to coopera tion The strongest support for the theory or at least for the idea that strong leadership is necessary has come from economists This en dorsement is rather amazing because economists with the notable exception of Kindleberger are likely to argue that markets by them selves will manage the world economy The most detailed and system atic empirical critique of HST by an economist is that of economic historian Barry Eichengreen 1989 39 However support for the the ory was not the purpose avowed by Eichengreen in fact he believed 38 Susan Strange criticized my argument that the irresponsible behavior of the United States was not due to Americas relative economic decline She was quite correct See Susan Strange The Persistent Myth of Lost Hegemony International Organization 41 no 4 1987 25974 39 Barry Eichengreen Hegemonic Stability Theories of the International Monetary System in Richard N Cooper et al Can Nations Agree Issues in International Economic Cooperation Washington DC Brookings Institution 1989 25598 94 I N T E R N A T I O N A L P O L I T I C A L E C O N O M Y that he had refuted the theory Through examination of the historical record Eichengreen tried to discover whether or not a hegemon had played a determining role in the rise and maintenance of an open world economy He inquired specifically into the roles of Great Brit ain in the late nineteenth century and of the United States in the post World War II era particularly regarding the genesis and functioning of the international monetary system Although he concluded that the record gave only modest support to the theory his analysis actually supports its validity Eichengreens lukewarm assessment of the theory appears to rest on the erroneous assumption that the hegemon must be an imperialis tic power that imposes its will on other countries His language sug gests that he identifies hegemony with coercion and imposition of the hegemons will on other countries Throughout his analysis he uses such terms as dictating force and coerced to describe the ac tions of the British and American hegemons Yet no proponent of the theory has used such language but instead each has emphasized the essential leadership role of the hegemon in promoting interna tional cooperation In fact Eichengreens analysis itself confirms that the British and American hegemons significantly influenced the na ture of the international monetary system through promotion of in ternational cooperation Without a hegemon international coopera tion in trade monetary and most other matters in international affairs becomes exceptionally difficult if not impossible to achieve Four years later 1993 Eichengreen again evaluated the theory of hegemonic stability from the perspective of historical experience 40 Whereas his earlier analysis had focused on the international mone tary system this subsequent evaluation considered the international trading system He stated that there was a positive association be tween hegemony and trade liberalization Comparing the nineteenth century and postWorld War II experiences Eichengreen concluded that the only example of successful multilateralism the historical re cord provides coincides with a period of exceptional economic domi nance by a single power And the growing difficulties of the GATT have coincided of course with US relative economic decline He then goes on to ask Why might this be Eichengreen drew upon cartel theory to explain why a hegemon facilitates international cooperation Simple cartel theory suggests that it is possible to deter defection from a cartel containing many 40 Barry Eichengreen in Jaime De Melo and Arvind Panagariya eds New Dimen sions in Regional Integration New York Cambridge University Press 1995 12021 95 C H A P T E R F O U R members only when there is a dominant firm capable of acting as enforcer In its absence duopolies of say neighboring firms may be the most that monitoring and enforcement capabilities can support This suggests that the growing prevalence of bilateralism is a corol lary of the increasingly multipolar nature of the world economy 41 Thus Eichengreen has set forth a plausible explanation of why the decline of American leadership has contributed to the increasing im portance of bilateral negotiations and regional arrangements in the world economy Other leading economists have also supported the validity of the theory For example Nobel Laureate Robert Mundell a distin guished expert on international monetary and financial affairs has pointed out that the stability of the international monetary system is dependent upon a dominant power Other international economists such as Robert Baldwin and Swiss economist Bruno Frey have also written in support of the idea that a hegemon is necessary Baldwin writes for example that the hegemonic role played by the United States increased the economic welfare of most nonCommunist coun tries 42 According to Frey public choice theory suggests that it is im possible for public goods to be provided if there is no hegemon 43 One of the most interesting arguments supporting the necessity of a hegemon was set forth by Mancur Olson Olsons views are especially apposite because of his innovative work on provision of collective goods and the fact that many critics of the theory cite his work to support their own criticisms Commenting on provision of the collec tive good of free trade Olson presents an ingenious theory based on domestic politics to explain why it is so difficult for a country to reduce trade barriers unilaterally and in the absence of external pres sures exerted by a powerful state 44 He then concludes Thus the world works better when there is a hegemonic powerone that finds it in its own selfinterest to see that various international collec tive goods are provided He continues Naturally the incentive a 41 Eichengreen in ibid 121 42 Robert E Baldwin Adapting the GATT to a More Regionalized World A Politi cal Economy Perspective in Kym Anderson and Richard Blackhurst Regional Inte gration and the Global Trading System New York St Martins Press 1993 Chapter 18 Bruno S Frey International Political Economics 43 Frey International Political Economics According to Frey Arrows impossibility theorem demonstrates that with three countries and three goals common or coordi nated policies cannot be reached when each country has a different ordering of priori ties Leadership is required to break the deadlock 44 Mancur Olson in De Melo and Panagariya eds New Dimensions in Regional Integration 12227 96 I N T E R N A T I O N A L P O L I T I C A L E C O N O M Y hegemonic power has to provide international collective goods dimin ishes as it becomes relatively less important in the world economy In the United States there has been a conspicuous resurgence of protec tionist thinking and a diminishing willingness of the country to pro vide foreign aid as the American economy has come to encompass relatively less of the world economy 45 From this perspective the emergence of new industrial powers and new exporters of manufac tured goods has resulted in increased American protectionist policies beginning with the New Protectionism in the mid1970s and with the shift to a greater emphasis on economic regionalism made manifest in the 1994 formation of the North American Free Trade Agreement 46 Lack of a counterfactual makes it impossible either to validate or refute the theory of hegemonic stability but Eichengreens empirical examination of the theory the supportive commentary of other econ omists and political scientists and the theoretical writings of Olson and others lend considerable support to its validity For these reasons even though the hegemonic stability theory HST does not provide a foolproof account of the eras of British and American leadership of the world economy it does hold up quite well by the standards of the social sciences including economics Governance of the Global Economy Creation of effective international regimes and solutions to the com pliance problem require both strong international leadership and an effective international governance structure Regimes in themselves cannot provide governance structure because they lack the most criti cal component of governancethe power to enforce compliance Re gimes must rest instead on a political base established through leader ship and cooperation Although many liberal scholars consider the concepts of hegemony and of regimes to be incompatible or even op posed to one another regimes governing economic affairs cannot function without a strong leader or hegemon The theory of hege monic stability posits that the leader or hegemon facilitates interna tional cooperation and prevents defection from the rules of the regime through use of side payments bribes sanctions andor other means 45 Ibid 125 46 Robert E Baldwin attributes the decline in US support for a multilateral system and the shift to regionalism to the loss of hegemony See Robert Baldwin Changes in the Global Trading System A Response to Shifts in National Economic Power in Dominick Salvatore ed Protectionism and World Welfare New York Cambridge University Press 1993 Chapter 4 97 C H A P T E R F O U R but can seldom if ever coerce reluctant states to obey the rules of a liberal international economic order The American hegemon did indeed play a crucial role in establish ing and managing the world economy following World War II strong support and cooperation were provided by the Cold War allies of the United States Moreover as Downs and Rocke point out regime compliance ultimately is dependent on domestic support PostWorld War II regimes rested on what John Ruggie called the compromise of embedded liberalism in which governments may and do inter vene in their domestic economies to promote full employment but must also conform to internationally agreedupon rules 47 Postwar trade liberalization was politically acceptable because governments pursued policies to guarantee full employment and to compensate those harmed by the opening of national markets to international trade Solution of the governance problem was for decades achieved through leadership international cooperation and domestic con sensus 48 The idea that a liberal international economy requires strong politi cal leadership by the dominant economic power was initially set forth by Charles Kindleberger in The World In Depression 19291939 1973 49 According to Kindleberger the scope depth and duration of the Great Depression were more severe because there was no leader to carry out several tasks necessary for the world economy to func tion properly Some of these tasks must be performed even in normal times others are needed in a crisis In normal times a leader must 1 maintain the flow of capital to poor countries 2 provide some order in foreign exchange rates at least among the key currencies and 3 arrange for at least moderate coordination of macroeconomic policies among the leading economies In times of crisis the leader in Kindle bergers words must provide open markets for distressed goods in depression and be a source of extrasupply when goods are tight as in the oil crises of 1973 and 1979 The economic leader must also be a lender of last resort in the event of a serious international financial 47 John Gerard Ruggie International Regimes Transactions and Change Embed ded Liberalism in the Postwar Economic Order in Stephen D Krasner ed Interna tional Regimes 195231 48 Governance involves the establishment and operation of social institutions or sets of rules that guide the interaction of actors This definition is set forth in Oran Young ed Global Governance Drawing Insights from the Environmental Experience Cam bridge MIT Press 1997 49 Charles P Kindleberger The World In Depression 19291939 Berkeley Univer sity of California Press 1973 98 I N T E R N A T I O N A L P O L I T I C A L E C O N O M Y crisis Lacking a leading country able and willing to discharge these functions financial crises can be followed by prolonged depressions as happened in the 1930s In short the functions of the leader are capital lending creation of a foreignexchange regime macroeco nomic coordination maintaining open markets and being the lender of last resort 50 Stephen Krasner and I each appropriated Kindlebergers basic idea that a political leader was needed to create and manage an interna tional liberal economy However each of us made several modifica tions that placed Kindlebergers insight within a statecentric intellec tual framework of political analysis and thus fashioned a statecentric version of the theory of hegemonic stability Both of us used the Greek word hegemon rather than leader to indicate that at times the leader had to exercise power to achieve its objective of establish ing and managing a liberal world economy A hegemon is defined as the leader of an alliance like that organized by Sparta to defeat the Persian invaders in ancient Greece or by the United States to defeat the Soviets Whereas Kindleberger argued that the leader created a liberal international economy for both its own and cosmopolitan eco nomic reasons Krasner and I have both argued that the hegemon created a liberal international economy primarily to promote its own interests and its politicalsecurity interests in particular Both of us have acknowledged that these security interests could also include the economic and military interests of allies When the United States played a central role in promoting an open and interdependent international economy composed mainly of the United States and its allies in order to strengthen the antiSoviet alli ance Americas motives were hardly altruistic Nevertheless despite the differences between Kindlebergers liberal version of the hege monic stability theory and the KrasnerGilpin statecentric version both approaches maintain that provision of such international public goods as free trade and monetary stability requires a dominant power with an interest in a liberal world economy and a willingness to ex pend economic and political resources to achieve and maintain that goal The theory of hegemonic stability maintains that there can be no liberal international economy unless there is a leader that uses its resources and influence to establish and manage an international economy based on free trade monetary stability and freedom of cap 50 Charles P Kindleberger The World Economy and National Finance in Historical Perspective Ann Arbor University of Michigan Press 1995 62 99 C H A P T E R F O U R ital movement The leader must also encourage other states to obey the rules and regimes governing international economic activities The theory assumes that a liberal international economy requires that cer tain public goods will be promoted by the leader A public good as originally defined by Paul Samuelson has the properties of non excludability inclusiveness and nonrivalrous consumption This rather obtuse jargon means that any individuals consumption of a public good does not affect decrease consumption of the good by others and that no one can be prevented from consuming the good whether or not he or she has paid for it A lighthouse of benefit to every ship whether or not the ship has contributed to the upkeep of the lighthouse fulfills such criteria In such a situation individuals and individual nations have an incentive to free rideto take ad vantage of the public good without paying for itsince no one can be excluded from enjoying the good This means that public goods will generally be undersupplied because few actors will have an incen tive to pay the costs of providing such goods 51 The public goods associated with a liberal international economy include an open trading system and a stable international monetary system However there are even greater tendencies toward free riding and for international public goods to be undersupplied within the international economy than in domestic affairs This problem can at least in theory be overcome by a small group of cooperating states however I know of no example of this type of cooperation on such a large scale as the world economy In practice public goods have been and can be provided only by a leader or hegemon with an interest in supplying the good for all or in forcing others to share payment for the good A brief examination of the British and American eras of interna tional leadership increases comprehension of the dynamics of the rise and erosion of a liberal world economy both eras of economic liber alism required a hegemonic power From the midnineteenth century to the outbreak of World War I Great Britain led the efforts for trade liberalization and monetary stability the United States has led the world economy since World War II 52 The liberal world economy in 51 For the case of international money consult Paul De Grauwe International Money PostWar Trends and Theories Oxford Clarendon Press 1989 2 52 My interest in the relationship between the structure of the international political system and the nature of the international economy was first aroused by my reading of E H Carr The Twenty Years Crisis 19191939 An Introduction to the Study of International Relations London Macmillan 1951 In this classic study of the collapse of the open world economy at the outbreak of World War I and the subsequent inabil 100 I N T E R N A T I O N A L P O L I T I C A L E C O N O M Y the late nineteenth century was truly global and was generally charac terized by nondiscrimination in trade unrestricted capital move ments and a stable monetary system based on the gold standard For decades the American system was composed only of the Free World during the Cold War it was characterized by trade discrimination by capital controls until the 1970s and by monetary instability after 1971 Whereas the British promoted and inspired free trade by exam ple and through a series of bilateral agreements the United States has championed trade liberalization through multilateral negotiations within the GATT Although there is disagreement on this subject according to Joanne Gowa security concerns did influence British trade policy 53 Certainly international security considerationsforg ing the Western alliance against the Soviet Unionplayed an ex tremely important role in Americas promotion of free trade 54 In the monetary realm the Bank of England played a central role in man agement of the gold standard in the nineteenthcentury system How ever even though the postWorld War II international monetary sys tem has been based on the dollar and subject to American influence the Federal Reserve has had to share pride of place with the German Bundesbank and other powerful central banks British economic decline began in the late nineteenth century as other countries especially Germany and the United States industrial ized Britain responded with a gradual retrenchment of its global posi tion and initiation of numerous measures to strengthen its security 55 Although Great Britain modified a number of its economic policies its huge dependence on trade forestalled a retreat into protectionism Nevertheless British leadership in trade liberalization did slacken ity of a weakened Great Britain to recreate a liberal international economy after the war Carr demonstrated that a liberal world economy must rest on a dominant liberal power Under the Pax Britannica Great Britain used its power and influence to create an open world economy in which markets largely determined trade flows and economic outcomes As the power of Great Britain waned in the latter decades of the century and finally collapsed in the interwar years the fortunes of an open liberal international economy suffered In the absence of British leadership the 1930s were characterized by economic conflicts among the great powers and the fragmentation of the world economy into spheres of influence dominated by one or another of these great powers 53 Gowa Allies Adversaries and International Trade 54 From a strictly economic perspective the United States after the war could have exploited its dominant economic position by imposing an optimum tariff on imports into its economy Instead it chose multilateralism mainly for political reasons One could say that the collective good provided by the American hegemon was the security of its allies 55 Robert Gilpin War and Change in World Politics New York Cambridge Univer sity Press 1981 101 C H A P T E R F O U R and by the 1930s Britain had retreated to a system of imperial prefer ences applied to the colonial empire and Commonwealth members As early as the mid1970s American political leaders business inter ests and scholars expressed strong concerns over the relative decline and deindustrialization of the American economy caused by foreign competition principally from the Japanese Such worries produced the New Protectionism As formal tariffs were reduced through trade negotiations the United States erected such nontariff barriers as those embedded in the MultiFiber Agreement 1973 in which many nations were assigned quotas the United States also imposed volun tary export restraints on Japanese products Responding to the bal looning American trade deficit intensifying fears of deindustrializa tion and rising protectionist pressures the Reagan Administration in the mid1980s significantly modified Americas commitment to multi lateralism It began to pursue a multitrack trade policy that has not only deemphasized multilateral negotiations but also increased unilat eralism and bilateralism especially managed trade with Japan along with economic regionalism through the North American Free Trade Agreement with Canada and Mexico Conclusion Although the science of economics is a necessary foundation for com prehension of international political economy this book focuses at tention on the interaction of markets and political actors Economics alone is an inaccurate and insufficient tool for analysis of such vital issues as the international distribution of wealth and economic activi ties the effects of the world economy on national interests and the effectiveness of international regimes This writer rejects the popular idea that universal economic laws and powerful economic forces now rule the global economy Despite increasing economic globalization and integration among national economies it is still necessary to dis tinguish between national and international economies Political boundaries do and will divide the economies and economic policies of one nation from those of another political considerations also sig nificantly influence and distinguish economic activities in one country from the next States and other powerful actors as well use their power to influence economic activities to maximize their own eco nomic and political interests 102 CHAPTER FIVE New Economic Theories A LTHOUGH NEOCLASSICAL economics is extremely useful in static analysis it does not provide an adequate conceptual framework for the analysis and understanding of economic change and the dynamics of the global economy for example it cannot ex plain the exogenous factors such as changes in taste and technology that are important in understanding the longterm dynamics of an economy Moreover as Paul Krugman has observed the neoclassical approach to economic affairs lacks both a temporal and a spatial dimension and assumes that economic activities take place in an ab stract universe devoid of history and geography 1 As a consequence it can not adequately analyze the historical development or geograph ical structure of an economy Most importantly despite general agreement in the economics discipline on the significance of techno logical progress for economic change and longterm growth neoclas sical economics gives inadequate attention to technology and the sources of technological change Neoclassical economics also ignores the importance of economic and other institutions 2 Although econo mists acknowledge that nations must establish rules to govern eco nomic activities provide a favorable environment for private entre preneurs and assist in overcoming market failures economic analysis gives short shrift to the role of governments and other institutions In recent years a number of economists have developed new theo ries that help to compensate for the limitations specified above As a group these novel and still highly controversial theoriesthe new growth theory the new economic geography and the new trade the orychallenge such fundamental assumptions of neoclassical theory as perfect competition constant returns to scale and complete infor mation These new theories emphasize the importance of oligopolistic competition economies of scale and technological innovation and they also incorporate historical processes institutions and spatial re 1 Paul R Krugman Geography and Trade Cambridge MIT Press 1991 2 An important analysis of the importance of institutions is Richard R Nelson and Sidney G Winter An Evolutionary Theory of Economic Change Cambridge Belknap Press of Harvard University 1982 103 C H A P T E R F I V E lations They facilitate understanding of a world economy character ized by discontinuities disequilibria and profound shifts over time in the global distribution of wealth and hence of power The world de scribed by the new theories is one of simultaneous divergence and convergence among national economies one in which governments can and do play a crucial role in economic affairs and in which tech nological innovation is a central feature Although the new theories have certainly not displaced conventional neoclassical economics they do challenge many of its assumptions and policy prescriptions and in some cases have led to modification of neoclassical principles For this writer the new theories provide important insights into the dynamics of both domestic and international economies Stressing the importance in economic affairs of history geography and sociopolitical institutions the new theories complement the in sights and analytic techniques of a statecentric approach to political economy They do of course have limitations and do not provide us with a complete understanding of economic change As these new theories either modify or complement mainstream neoclassical eco nomics I shall begin my discussion with an examination of several important limitations of neoclassical economics as a tool for under standing the dynamics of the global economy Change and Neoclassical Economics Because neoclassical economics does not consider history and geogra phy when explaining economic affairs it has limited applicability to comprehension of the functioning of the economy over time and across space Indeed neoclassical theory generally ignores the changes in economic political and other social structures that inevitably re sult from economic growth The disciplines focus on equilibrium ac tually inhibits understanding of the role of economic forces in the evolution of the economy Neoclassical analyses provide neither a history of the economy nor an explanation of its evolving nature However without a history of the growth process and its effects on the power and interests of major actors it is hardly possible to understand the dynamics of the world economy Furthermore neoclassical economics does not add a great deal to comprehension of the geographic distribution of economic activities within and across national economies the evolution of trad ing patterns or the spatial development of the economy Although neoclassical economists believe that the territorial distribution of eco 104 N E W E C O N O M I C T H E O R I E S nomic activities is of little consequence as long as every economy is behaving according to the law of comparative advantage the ques tion of which countries produce whatpotato chips or computer chipsis of the utmost importance to groups nations and regions around the world The geographic distribution of the international division of labor and the ways in which the spatial organization of economic activities change over time are among the most contentious issues in the world economy The failure of mainstream economists to give sufficient attention to technological innovation is an especially glaring limitation In the traditional approach of neoclassical theory there are several weak nesses 1 Because technological advance is considered exogenous to the economic system economists have developed no comprehensive explanation for it 2 because economists consider technology to be a public good to which everyone has equal access they do not ade quately recognize the importance of monopolies of technology and 3 because the theory of the production function assumes that eco nomic actors have complete or certain knowledge of and access to available technology economists frequently fail to integrate uncer tainty into their writings 3 Rather than technology being a public good equally available to all economic actors in reality national dif ferences in innovation and utilization of technology have become vital determinants of variations in national rates of economic growth na tional competitiveness and international trade patterns Although there is some effort being made to incorporate a more realistic view of technology into neoclassical economics such efforts have not gone far enough Many economists acknowledge that institutions social political economic do play a role in the outcome of economic activities how ever their emphasis on the market leads many and maybe most to ignore the significance of institutions Even those who do take institu tions seriously give little attention to their origins and functions Ex plaining institutions as resulting from the attempts of rational individ uals to maximize their interests neoclassical institutionalists for example generally overlook the role of chance events and ideology in the origins of economic and other institutions New insights pro vided by the concepts of path dependence and cumulative processes explain how historical accidents and nonrational events can have a 3 Maurice Fitzgerald Scott A New View of Economic Growth Oxford Clarendon Press 1989 7274 94 105 C H A P T E R F I V E powerful impact on the evolution of those institutions that shape eco nomic affairs 4 Although the new concepts attempt to overcome the inherent limitations of neoclassical theories they have by no means overturned the basic theories or the assumptions of conventional eco nomics World View of the New Theories As Paul Krugman has argued the new trade growth and other eco nomic theories have profound implications for the analysis and func tioning of the international economy They provide a world view of economics very different from most of pre1980 theory they include increasing returns and imperfect competition multiple equilibria a crucial role for history accident and selffulfilling prophecy In this new and still controversial economic universe there are arbitrary and accidental components that affect international economics 5 As a group the new theories introduce both spatial and temporal dimensions into economic analysis place technological innovation at the center of their analyses and assign a prominent role in the econ omy to such institutions as national governments and corporations The new endogenous growth theory new economic geography and new strategic trade theory have important implications for the study of international political economy Based on the fundamental behavioral assumption of neoclassical economics that society is composed of rational individuals whose pri mary purpose is to maximize their interests these new theories depart from conventional neoclassical economics as they 1 assume that there are imperfect or oligopolistic markets 2 emphasize the impor tance of technological innovation and 3 utilize history or path de pendence as an explanatory variable Together these novel theories remain highly controversial and the evidence supporting them cannot be characterized to use the language of economists as robust With this caveat in mind what are the common elements in the three theories that make them important for the study of international po litical economy Institutions Scale Economies and Imperfect Competition All three theoriesthe new growth theory the new economic geogra phy and the new trade theoryare based on the assumption of im 4 W Brian ArthurPath Dependence in the Economy Scientific American Febru ary 1990 9299 5 Krugman Geography and Trade 89 106 N E W E C O N O M I C T H E O R I E S perfect or oligopolistic competition in which markets are dominated by a few large firms These new theories depict the economy as basi cally oligopolistic because of increasing returns to scale cumulative processes or some other market imperfections They recognize the existence of powerful actors with some control over market forces Indeed especially in the leading technological sectors a relatively small number of large firms such as Siemens Microsoft and Matsu shita actually dominate the market The new theories have all been strongly influenced by research de velopments in the field of industrial organization This research which emphasizes the importance of scale economies and of imperfect competition in the organization of industrial sectors and the overall economy challenges the assumption that all economic processes are characterized by constant returns and perfect competition Conven tional theory for example argues that if a firm doubles the input of both capital and labor the output of the firm will only double and will at some point produce diminishing returns this assumption places limits on an individual firms capacity to dominate a market If on the other hand scale economies and increasing returns to scale do exist doubling both inputs would more than double the output and therefore would increase the firms productivity Consequently in an industry characterized by increasing returns a firm with a head start can increase its output and decrease its average costs much more rapidly than competitors just beginning production Indeed such a cost advantage could enable an existing domestic firm to establish a monopolistic market position also the region or nation in which such oligopolistic firms are located could itself grow more rapidly than other regions and nations In time the regionnation with oli gopolistic firms could surpass and eventually dominate other regions or nations In this way the new theories have profound implications for the study of international political economy Technological Innovation The new theories emphasize strongly the importance of technological developments for economic growth the spatial location of economic activities and international competitiveness Technological innova tion has become the primary determinant of economic growth in ad vanced economies and also of international competitiveness among industrialized economies In fact these new theories permit one to consider technology or knowledge as a separate factor of production The growth rates of national economies the patterns of international trade and the overall structure of the international economy have 107 C H A P T E R F I V E become increasingly dependent upon a nations technological capabil ities The increased importance of technological innovation in turn has given every government a strong interest in the technological strength of its economy and has stimulated technonationalismef forts by governments to prevent diffusion of their most important technologies Competition among national economies for technologi cal superiority has become a major feature of the international politi cal economy History and Geography The economic universe portrayed by the new theories is very different from that encountered in formal economic theories where the econ omy of neoclassical economists occupies neither time nor space and the equations that define the neoclassical economy and determine market equilibrium are solved simultaneously in a timeless void What we noneconomists recognize as the economythat is a geo graphic space with a name like the American economy or the British economyfinds no place in formal economic theory Neoclassical economists assume that the national economy is nothing more than a dimensionless point in space and the international economy is only a set of interconnected points 6 The New Theories The newer theories assume that history and geography are crucial to the definition of the nature and functioning of the economy that the economic past largely determines the economic present and that eco nomic activities have a distinct spatial and hierarchical structure They do not share the neoclassical assumption of an economic uni verse populated by powerless actors dispersed evenly throughout a timeless and dimensionless economic space Theory of Endogenous Growth Possessing important implications for understanding the dynamics of the international political economy the controversial new growth theory or theory of endogenous growth was first set forth by Paul Romer 1986 and Robert Lucas 1988 7 This theory leads to 6 Ibid 2 7 Paul M Romer Increasing Returns and LongRun Growth Journal of Political Economy 94 no 5 October 1986 100237 Robert E Lucas Jr On the Mechanics of Economic Development Journal of Monetary Economics 22 no 1 July 1988 342 108 N E W E C O N O M I C T H E O R I E S conclusions that run counter to the ideas of conventional neoclassical economics regarding the role of the state in the economy the institu tional framework of economic activities and the highly uneven distri bution of wealth in the international economy To appreciate the sig nificance of the new growth theory it is essential to review the neoclassical theory of longterm economic growth These contradic tory theories disagree on economic policies and the role for govern ments in economic affairs Background The neoclassical explanation of longterm economic growth is based on formal economic models set forth by Robert So low in the late 1950s 8 almost all subsequent work on economic growth has been an elaboration of his pioneering ideas He argued that economic growth is a product of capital accumulation labor in put and technical progress 9 His theory is based on the neoclassical production function in which the economic output of an economy is dependent on the quantity of capital and labor employed and the theory of the production function itself is based on certain critical assumptions It assumes that there are constant returns to scale and that if the amount of both capital and labor employed in producing a widget are doubled the output will double phrased differently there are no increasing returns to scale Another assumption is that marginal returns diminish over time that if there is no additional technological progress and if either the amount of capital is increased while the size of the work force remains stable or vice versa succes sive additional investments will produce only decreasing gains in out put the law of diminishing returns 10 Following this reasoning econ omists conclude that the larger the capital stock in place the smaller the benefit of each increment in capital investment 11 The neoclassical theory of economic growth concludes that eco nomic growth or the rate of growth in output is a consequence of the rate of increase in labor input the rate of growth of capital input and the rate of technical progress and that accumulation of the fac 8 The theories are discussed in Jeffrey D Sachs and Felipe Larrain Macroeconomics in the Global Economy Englewood Cliffs NJ PrenticeHall 1993 Chapter 18 9 Ibid 55556 10 Adam Szirmai Bart Van Ark and Dirk Pilat eds Explaining Economic Growth Amsterdam North Holland 1993 8 11 N Gregory Mankiw David Romer and David N Weil A Contribution to the Empirics of Economic Growth Quarterly Journal of Economics 107 no 2 May 1992 40737 109 C H A P T E R F I V E tors of production accompanied by technical change accounts for the longterm growth of an economy 12 Over the long term economic growth is dependent upon techno logical progress which raises labor productivity and counters the in herent tendency toward diminishing returns 13 Economists argue that a sustained increase in real GNP must be due either to an increase in the quantity of capital and labor used in production or due to more efficient use of these inputs eg technical andor organizational progress Although empirical models of economic growth can deter mine the contribution of each cause to economic growth they cannot explain the factors causing the growth of capital labor andor tech nology Neoclassical growth theory leads to the conclusion that govern ment policies can do little to accelerate the longterm rate of eco nomic growth That rate is determined by what Solow called the steady state which is defined as that point in economic growth when capital per worker reaches an equilibrium and remains un changed This means that any attempt to accelerate the growth rate of such an economy by increasing the savings rate or the amount of capital investment will have only a slight or transitory effect on the longterm rate of economic growth A governmentinduced sustained increase in capital investment for example has only a temporary im pact on the longterm growth rate Although the ratio of capital to labor may increase the marginal product of capital will decline and thus will reduce the effectiveness of the investment While the govern ment can do some things at the margin such as increasing the na tional rate of savings or the supply of effective labor such efforts will not have a major impact over the long term 14 Another important implication of the neoclassical growth theory for international affairs derives from the convergence theory or hy pothesis This hypothesis posits that labor productivity and per capita income levels of the relatively less developed countries should over the long run converge or catch up with those of the more developed countries 15 Due to the technological gap between developed and less developed countries LDCs can make large productivity gains by bor 12 Sachs and Larrain Macroeconomics in the Global Economy 556 13 Shahrokh Fardoust and Ashok Dhareshwar LongTerm Outlook for the World Economy Issues and Projections for the 1990s International Economic Analysis Working Paper No 372 Washington DC World Bank February 1990 65 14 This discussion is based largely on Sachs and Larrain Macroeconomics in the Global Economy 15 Fardoust and Dhareshwar LongTerm Outlook for the World Economy 72 110 N E W E C O N O M I C T H E O R I E S rowing technology from the technological leaders Over time the dif fusion of capital technology and knowhow from rich to poor will enable the less developed countries to increase their rates of economic growth both in absolute terms and in relation to the more advanced economies Moreover investment in poor countries should produce more rapid growth and greater increases in output than equivalent investment in rich countries in the former there will be higher mar ginal returns to inputs while in the latter marginal returns will de cline Thus according to convergence theory the rich will get rich more slowly and the poor will get richer more rapidly so they will gradually converge with one another and income inequalities between rich and poor countries will be eliminated 16 Limitations An important criticism of the neoclassical growth theory focuses on its treatment of technology Although the theory teaches that technological progress bears the primary responsibility for in creases in per capita income over the long run the theory does not explain the determinants of technological advance Despite the central importance of technology as the ultimate determinant of longterm economic growth the theory can explain neither economic change nor innovation 17 The theory considers technological progress to be exogenous to economic growth and technology to be embodied in capital investment Moreover technology is considered a public good to which every firm anywhere in the world has access Furthermore technology unlike capital and labor cannot be ob served or measured directly so it must be the residual or Solow residual after the contributions of the other two factors to total factor productivity and to overall economic growth have been taken into account 18 The term residual however is quite misleading Whereas 12 percent of the doubling of American productivity growth between 1909 and 1949 can be explained by the expansion of capital per worker the residual or total factor productivity accounted for the other 88 percent increase Some residual As Sachs and Larrain have commented the residual is really a measure of our ignorance 19 As a consequence the neoclassical theory based on factor accumulation 16 Walter Rostow Why the Poor Get Richer and the Rich Slow Down Essays in the Marshallian Long Period Austin University of Texas Press 1980 17 Joseph Stiglitz Comments Some Retrospective Views on Growth Theory in Peter Diamond ed GrowthProductivityUnemployment Essays to Celebrate Bob So lows Birthday Cambridge MIT Press 1990 5068 18 Ibid 556 19 Sachs and Larrain Macroeconomics in the Global Economy 556 111 C H A P T E R F I V E can explain only a small portion of what it purports to explain For example the theory cannot explain the persistently large gap in wealth between rich and poor countries 20 Despite these serious limi tations and lacking any satisfactory alternative the neoclassical the ory is considered by most economists to be generally correct because it does what it is meant to do 21 Another criticism is that the original theory neglected human capi tal and knowledge skills Work by Edward Denison and others dem onstrated the crucial role of education in economic growth and hence the importance of investment in human capital 22 Other studies have indicated that due to positive investment externalities investment in physical and human capital may contribute more to economic growth than the original neoclassical theory suggested although investment improves the productivity of the investing firm technological and other spillovers can also benefit other national firms and even the entire economy For example such positive externalities may explain why since World War II the return on capital investment in the in dustrialized countries has been much greater than neoclassical theory had predicted Research in industrial organization which emphasizes the importance of increasing returns to scale and the crucial role of research and development R D has raised doubts about the basic assumptions of neoclassical growth theory These ideas and others have been incorporated by Romer and Lucas into the new endoge nous theory of economic growth The New Endogenous Growth Theory Technological innovation and advances in knowledge are at the core of the differences between the neoclassical model and the new endogenous growth theory 23 Whereas the neoclassical model builds on only two factors of produc tion labor and capital treats technology or knowledge as an exoge nous factor and assumes that progress in technology is produced by random scientific and technological breakthroughs the new theory 20 Maurice Obstfeld and Kenneth Rogoff Foundations of International Macroeco nomics Cambridge MIT Press 1996 473 21 Mankiw Romer and Weil A Contribution to the Empirics of Economic Growth 22 Cited in Sachs and Larrain Macroeconomics in the Global Economy 558 23 Many if not most of the central ideas in the new growth theory had been set forth earlier by other economists including Joseph Schumpeter Kenneth Arrow Christopher Freeman Richard Nelson and Sidney Winter A valuable history and critique of the theory is in Richard Nelson How New Is New Growth Theory Challenge 40 no 5 SeptemberOctober 1997 2958 Nelson himself attributes much of the new think ing about economic growth to Moses Abramovitz 112 N E W E C O N O M I C T H E O R I E S incorporates technological progress and advances in knowledge as en dogenous factors within the growth model Technological advance is considered endogenous because technological innovations are the re sult of conscious investment decisions taken by entrepreneurs and in dividual firms Firms are assumed to invest in research and develop ment activities for the same reasons that they invest in other factors of production that is on the basis of the expected profitability of the investment In effect the new growth theory assumes that knowledge technology andor knowhow constitute a separate factor of pro duction in addition to capital and labor The concept of knowledge or technology as a separate factor of production has important implications for understanding economic growth Knowledge of how to do or make things can raise the pro ductivity of the other two factors Whereas knowledge and technol ogy just happen in the neoclassical model the new theory assumes that they result from conscious decisions and that technological ad vance is largely marketdriven Investment in capital and knowledge can stimulate and reinforce one another in a virtuous circle of cu mulative causation so that acceleration in the rate of capital invest ment can raise the longterm growth in per capita income In addi tion whereas neoclassical growth theory is based on the assumption of constant returns to scale the new theory is based on the existence of economies of scale Thus whereas neoclassical theory predicts that the rate of longterm growth will decline because of diminishing returns the new theory postulates that the possibility of increasing returns means that the growth rate need not decline The new growth theory is important because it permits or even encourages the use of government policies to increase the longterm rate of economic growth Whereas neoclassical theory assumes that diminishing returns eventually place an upper limit on the returns to capital accumulation and hence on the longterm rate of economic growth the new growth theory assumes that increasing returns to scale and positive investment economies can lead to an increased growth rate especially in hightech sectors Whereas the neoclassical theory regards the savings rate as having only a modest effect on the longterm growth rate and technology as exogenous endogenous growth theory suggests that government policies through promotion of an increased national savings and investment rate and also in creased support for R D can lead to a sustained higher rate of economic growth Romer makes several important points regarding the new growth theory 113 C H A P T E R F I V E 1 Investment in knowledgecreation and R D activities by profit seeking entrepreneurs is an important determinant of economic growth 2 While the results of R D are partially captured or appropriated by the investing firm some of the results are not captured but spill over and constitute public goods that can be exploited by other firms thus stimulating economic and productivity growth throughout an economy 3 Nevertheless most of the benefits of the new technology are cap tured by the investing firm and give it a competitive advantage over its rivals this can lead to an oligopolistic market 4 Firms tend to underinvest in R D and governments should take appropriate actions to overcome this market failure 5 A nations human capital and skills determine its longterm growth rate and its success in economic development 24 The new growth theory has many important implications for the nature of the economy and the status of neoclassical economics The new theory is inconsistent with the fundamental assumption in neo classical economics of perfect competition that is the belief that firms are pricetakers because prices are determined by the market and firms cannot easily change the prices they charge Although neoclassi cal theory assumes that if a firm should lower its price to increase its market share and should also increase its production the increased output will not lead to economies of scale but only to lost profits the new growth theory assumes that because increasing returns are possible increasing output lowers unit costs and the firm can there fore increase its profit And this means that the firm is a price setter rather than a pricetaker To the extent that the new growth theory is correct the market must be viewed as an imperfect or oligopolistic market rather than as a perfect one The new growth theory has engendered considerable controversy within the economics profession Some critics charge that there is nothing especially novel about the new theory asserting that its au thors have merely codified in their model the technological innova tion monopolistic pricing and increasing returns that have long been familiar to economists Other critics argue that the traditional vari ables of growth such as capital investment and increases in the labor supply have far greater explanatory power than the new theory sug 24 Paul M Romer Endogenous Technological Change Journal of Political Econ omy 98 no 5 October 1990 S71 114 N E W E C O N O M I C T H E O R I E S gests 25 Although Solow himself has praised the new growth theory he believes that the theoretical foundations underlying the theory are simply not credible the absence or presence of diminishing returns he points out is difficult to test Arguing that the forces governing economic growth are complex mostly technological and even a lit tle mysterious Solow has commented that economists are ignorant of the forces propelling the growth process and thus are incapable of providing governments with policy advice that would enable them to raise substantially the national rate of economic growth 26 Perhaps I would add one cannot improve significantly on Keyness attribution of economic growth to the existence of animal spirits Despite the controversy surrounding the new growth theory Elha nan Helpmans conclusion that it is an important complement to the neoclassical theory does appear warranted 27 As he argues few of the variations in economic growth among national economies are ex plained by the neoclassical formulation which has been primarily concerned with capital accumulation Romer and Lucas on the other hand rely on the proposition that learning by doing can result in decreasing costs and scale economies They have applied this impor tant idea to the accumulation of knowledge and human capital and this Helpman believes may be their most important contribution Romer and Lucas have taken the view that aggregate production ex hibits increasing returns to scale and they have noted that some of those returns accrue to a specific economic sector rather than just to an individual firm The inability of a firm to monopolize all the results of its investment in R D and the presence of spillovers mean that the social rate of return on such investment is more than twice the private rate of return Thus by combining imperfect competition or economies of scale with learning by doing and innovation Helpman argues Romer and Lucas have developed a model that helps explain longterm growth in per capita income The implications of the new theory for economic policy are very important As Helpman suggests the new theory means that public policy can significantly increase the rate of economic growth In the new growth theory technical progress is recognized as being profit motivated endogenous and driven by the investment rate The rate of innovation and hence of economic growth can be increased by 25 N Gregory Mankiw The Growth of Nations Brookings Papers on Economic Activity No 1 Washington DC Brookings Institution 1955 26 Robert Solow IMF Survey 16 December 1991 378 27 Elhanan Helpman Endogenous Macroeconomic Growth Theory European Economic Review 36 nos 23 April 1992 23767 115 C H A P T E R F I V E appropriate industrial and government policies that increase expendi tures on knowledge creation research and development and such human capital formation as education and training To the extent that government policies can facilitate creation of new knowledge and technology there will be an effect on the distribution of wealth and power within the global economy Some economists and political economists have applied the new economic theory to explain the rapid industrialization of the dynamic Pacific Asian economies Another important implication of the new growth theory is that political economic and other institutionsfrom governments to uni versities to corporationscan either hinder or facilitate technical ad vance and hence longterm economic growth Differing from the neo classical economics assertion that free markets tend to produce efficient outcomes the new growth theory suggests that national eco nomic structures institutions and public policies are major determi nants of technological developments and economic growth In fact long before the new growth theory was formulated by Romer and Lucas a number of economists and political economists had engaged in pioneering work on the determinants of innovative activities and the diffusion of technical knowledge in the production process Among the most important contributors to an understanding of na tional systems of innovation are Christopher Freeman Richard Nel son and Keith Pavitt whose writings have demonstrated the crucial role of technological advance in economic growth and the dynamics of economic systems 28 The new theorys emphasis on human capital as the key to eco nomic growth weakens convergence theory and this has significance for the nature and dynamics of the global economy The new growth theory suggests that under some conditions an initial advantage of one country over another in human capital will result in a permanent difference in income level between the countries As Jeffrey Sachs and Felipe Larrain have pointed out when human capital endowment is important a rich country can maintain its lead indefinitely over poorer countries by generating sufficient new savings and invest ment 29 According to the theory the rich will get richer the poor unless they invest in human capitalwill continue to lag behind and the international economy will continue to be characterized by large 28 Richard R Nelson High Technology Policies A FiveNation Comparison Wash ington DC American Enterprise Institute 1984 and Christopher Freeman Ray mond Poignanat and Ingvar Svnnilson Science Economic Growth and Government Policy Paris OECD 1963 29 Sachs and Larrain Macroeconomics in the Global Economy 57980 116 N E W E C O N O M I C T H E O R I E S inequalities among nations Thus the new growth theory implies that the uneven growth of national economies rather than their conver gence is the characteristic pattern of the global economy To summarize the new growth theory has important implications for political economy and for the structure of both international and domestic economies It implies that the rate of economic growth in advanced economies need not decline convergence between rich and poor is not automatic imperfect or oligopolistic competition will ap pear in many industries especially hightech industries due to in creasing returns and government policies can have a major and posi tive impact on an economys longterm rate of economic growth If as the theory assumes there are increasing returns to scale economies do not inevitably reach a steady state of economic growth rather deliberate policy decisions by governments can encourage continued capital accumulation and result in a higher rate of selfsustaining eco nomic growth 30 The New Economic Geography Another new theory important to the study of international political economy IPE is the new economic geography NEG 31 The cen tral question addressed by NEG is Why do economic activities espe cially in particular industries tend to be heavily concentrated in cer tain geographic locationscities or regionsand why do these concentrations generally persist over very long periods Indeed the existence and endurance of certain regional concentrations of eco nomic activities provide a startling aspect of the geography of eco nomic life Regional economic clusters and their persistence cannot normally be explained by the neoclassical emphasis on factor endow ments Although the principle of comparative advantage argues that the location of an industry will be determined principally by factor endowments factor endowments do not and cannot explain the loca tion of many important industries Although NEG does not deny the relevance of comparative advantage or the economics of location it does argue that noneconomic factors path dependence chance and cumulative processes frequently account for the origins and concen 30 Ibid 571 31 This section is based on Krugman Geography and Trade and other writings by Krugman Many of the key ideas on the spatial nature of economic activities have long been stressed by noneconomists especially regional geographers Two of Krugmans major contributions were to explain spatial concentrations through the use of a model based on economies of scale and to introduce these ideas into the mainstream of eco nomics 117 C H A P T E R F I V E tration of manufacturing and many other economic activities in par ticular locations 32 The persistence of regional concentrations of economic activities or the coreperiphery model of the structure of an economy has long been of great interest to Marxists dependency theorists and other scholars on the political left who attribute the coreperiphery structure to capi talist imperialism and exploitation While some conservative scholars have acknowledged the prevalence of the coreperiphery structure they have been unable to provide or have been uninterested in providing a satisfactory economic explanation of the universal tendency toward economic agglomeration Although economic geographers have long been interested in the spatial organization of economic activities their theories have unfortunately been ignored by economists and have not been incorporated into economics nor sufficiently integrated within the political economy literature In the late twentieth century some econo mists did attempt to explain the coreperiphery structure of the econ omy through the new economic geography Their explanation has con siderable relevance for the study of IPE 33 According to NEG the initial location and concentration of eco nomic activities in a particular region is frequently a matter of mere chance or historical accident However once an industry or economic activity is established cumulative forces and feedback mechanisms can lead to continued concentration of economic activities in that region for an extended period of time Selfreinforcing processes mean that the evolution of a regional economy and its structure are largely determined by what Brian Arthur and Paul David have labeled the phenomenon of path dependence 34 According to this simple but pow erful idea the historical past and cumulative processes largely deter 32 Most geographers undoubtedly characterize the new economic geography as the rediscovery of the wheel Much that Krugman and others have written has already appeared in the literature of geography and is another example of the failure of econo mists to explore what historians and other social scientists have written A valuable critique of the new economic geography by a geographer is Ron Martin The New Geographical Turn in Economics Cambridge Journal of Economics 23 no 1 Janu ary 1999 6591 A commentary on the slighting of geography by Krugman appears in The Economist 13 March 1999 92 33 The literature on coreperiphery economic structures is extensive A useful survey is in Arie Shachar and Sture Oberg eds The World Economy and the Spatial Organi zation of Power Aldershot UK Avebury 1990 34 An important discussion of path dependence is in W Brian Arthur SelfReinforc ing Mechanisms in Economics in Philip W Anderson Kenneth J Arrow and David Pines eds The Economy as an Evolving Complex System The Proceedings of the Evolutionary Paths of the Global Workshop published for the Sante Fe Institute Stud ies in the Sciences of Complexity 1988 Vol 5 118 N E W E C O N O M I C T H E O R I E S mine the choices available to a decisionmaker and the context within which decisions are made Path dependence thus implies that the eco nomic universeproductive technologies economic institutions and the geographic distribution of economic activitiesis largely the con sequence of many minor random developments Whereas conven tional economics assumes that the magnitude of a cause determines the magnitude of its effect ie there is a linear relationship between the two path dependence analysis indicates that small and even very small causes can give rise to disproportionately large effects The important implications of path dependence for neoclassical theory may be illustrated by the theory of the production function This theory on which neoclassical growth theory is based assumes that an entrepreneur selects from the range of available technologies The rational entrepreneur will select the most efficient combination of factors of production and technological options The key word here is available According to the path dependence idea many of the technologies available to an entrepreneur are like economic institutions the result of random events and are not necessarily the most efficient Indeed especially in the area of advanced technologies or hightech industries some of the specific technologies available are not particularly efficient Inferior and less efficient technologies can get locked in and be adopted rather than those that most technical experts would judge to be equal or even superior An example is the complete victory of the Matsushita VHS standard for a VCR over Sonys equally good if not superior Betamax format However the most frequently cited example is the layout of the keyboard on a typewriter or a computer The inefficient QWERTY layout was chosen because the keys of the first typewriters became jammed and there fore the keyboard was deliberately redesigned to slow the speed of the typist modern computers operating at nanosecond speeds retain this builtin inefficiency However my favorite example is even closer to my heart I am writing these lines on a Macintosh computer It is well known that Macintosh users are fiercely loyal and I include myself in this number Any objective observer would have to grant that Macintosh hardware and software are far superior technically to their rivals in the Wintel world of computers using the Windows operating system and the Intel chip 35 Yet in the 1980s and 1990s the Macintosh share of the market deteriorated alarmingly and the future of the company was in serious doubt The principal reason for this decline does not 35 Wintel refers to Intel computers using the Microsoft operating system 119 C H A P T E R F I V E lie in the technology or the intrinsic quality of the competing prod ucts but in a number of serious marketing and other blunders made by successive Macintosh leaders The personal computer PC gained a great advantage over the Macintosh due to huge economies of scale and decisively lower costs that could be credited in large part to Win tels overwhelming share of the market this meant that rational busi ness persons equipping a company were much more likely to purchase Wintel computers than the superior and easier to use Mac Path dependence implies that a region or nation can have a domi nant position in a particular industry simply for historical reasons Industry concentration and a nations trading patterns are not due to factor endowments alone but may be due to the regions almost accidentally having achieved a head start in an industry Such a head start has frequently enabled industries in a region to achieve econo mies of scale and to increase their efficiency through learning by do ing thus establishing and maintaining a decisive lead over potential rivals There are many examples of industries or economic activities that cluster in a particular region due to an arbitrary event and the effects of path dependence for example the production of automo biles in Detroit and the computer industry in Silicon Valley The new economic geography substitutes imperfect competition for the neoclassical assumption of constant returns and perfect competi tion NEG also assumes factor mobility and falling costs of transpor tation between the periphery and the core region The interactions of increasing returns decreasing transportation costs and factor mobil ity can lead to further agglomeration or concentration of economic activities within the core region Regions with a head start attract industries and economic activities from other regions supplyandde mand factors reinforce one another as suppliers want to concentrate near large markets and the concentration of suppliers in the region increases local demand 36 As these various linkages positive feedback mechanisms and cumulative causation interact over time an eco nomic structure is created This structure is composed of a dominant core in which powerful oligopolistic firms are heavily concentrated and a less developed and economically dependent periphery The rela tively selfsustaining coreperiphery geographic structure character izes all modern economic systems 37 36 Krugman Geography and Trade 71 37 For a detailed discussion of the advantages of the core over the periphery consult Alfred Weber Alfred Webers Theory of the Location of Industry Chicago University of Chicago Press 1929 120 N E W E C O N O M I C T H E O R I E S Stated simply a coreperiphery structure is determined primarily by the interaction of scale economies and the costs of transportation 38 If economies of scale were the only factors involved in the location of industry one would expect that the world economy as a whole would be characterized by a single or just a few coreperiphery structures Instead as we know the world economy and even some large na tional economies have a number of core regions This multiple core structure of the international economy is explained primarily by the cost of transportation reductions in transportation costs tend to in crease economic concentration and increases in transportation costs have the opposite effect However additional forces are at work in determining the coreperiphery structure For example such centrifu gal diffusion or decentralizing forces as rising wages and land rents in the core encourage industries to move into the lowercost periphery and thereby counter the centripetal polarizing agglomeration or concentration forces that pull economic activities inward toward the core Also every government engages in deliberate efforts to erect barriers or provide inducements that will make either the centripetal or the centrifugal forces work toward their own advantage A notable example was Canadas National Policy which utilized trade barriers to encourage American and other firms to invest in the Canadian economy and to thereby industrialize that country A nation that possesses one or more regional cores with strong industries can achieve an overwhelming and continuing competitive superiority over others A region with a head start in the accumula tion of knowledge often widens its productivity lead The great effects of a head start motivate lagging nations to pursue particular indus trial policies including subsidies erection of protectionist barriers and other actions that may help them to catch up and to possess important core regions of their own Possession of a core region is considered to be of immense political importance because it is associ ated with high wages industrial power and national autonomy The above model of regional concentration and diffusion is impor tant to the nature and dynamics of the world economy It implies that lowering trade or other economic barriers and the ensuing process of economic integration will create a coreperiphery structure in which industry and other economic activities will migrate to the core region as barriers are decreased In effect increasing economic interdepen 38 As Krugman demonstrated in his Geography and Trade the coreperiphery struc ture is explained by the interplay of economic forces and historical developments Also see Paul Krugman and Maurice Obstfeld International Economics Theory and Policy 3d ed New York HarperCollins 1994 18485 121 C H A P T E R F I V E dence among national economies means that many economic activi ties will concentrate in a small number of regions populated by oli gopolistic firms that enjoy economies of scale andor lower transport and transactions costs This process explains why uneven develop ment of regions and nations characterizes both national and interna tional economies This tendency toward a coreperiphery structure has profound implications for the future economic structure of West ern Europe as internal barriers come down and progress is made to ward creation of a single market In an increasingly integrated world economy in which coreperiph ery structures spread across national boundaries the presence of core regions exclusively controlled by a single nation and of a periphery composed of other nations will necessarily lead to economic tensions and even political conflict between the dominant core economy and dependent peripheral economies Escaping economic dependence and achieving political independence is an objective of every society Core economies wish to maintain their dominant position and peripheral economies wish to become core economies in their own right The efforts of the dependent peripheral economies to escape domination by wellestablished regional cores and the efforts of the cores them selves to maintain their dominant position are crucial factors in the dynamics of the world economy Thus growing integration of the world economy has led to increasing efforts by individual nations threatened regions within those nations and such interstate regional alliances as the European Union to protect themselves against the cen tralizing forces of economic globalization The new economic geogra phy implies that the structure of strong core economies and depen dent peripheries will continue to produce economic tensions and occasional political conflict Strategic Trade Theory The new strategic trade theory is the culmination of several earlier developments that have modified conventional trade theory which was based on factor endowments or comparative advantage and was developed in the early 1930s by Eli Heckscher and Bertil Ohlin This HeckscherOhlin or HO model of comparative costs or advantage postulated that a country would specialize in the production and ex port of those goods or services in which it had a cost advantage over other countries the model was based on the familiar neoclassical as sumptions Strategic trade theory or STT developed from economists grow ing appreciation of imperfect competition economies of scale learn 122 N E W E C O N O M I C T H E O R I E S ing by doing the importance of R D cumulative processes and technological spillovers 39 STT challenges the theoretical foundations of the economics professions previously unequivocal commitment to free trade In fact the development of STT was stimulated by growing dissatisfaction with conventional trade theorys inability to explain trade patterns and by concern about the increasing trade problems of the United States especially with Japan in the 1980s The application to trade theory of novel methods associated with important theoreti cal advances in the field of industrial organization provided the means to develop an alternative to the HO theory Mathematical models of imperfect competition and game theoretic models had been incorpo rated into trade theory in the early 1980s by James Brander and Bar bara Spencer 1983 theorists of industrial organization and by the work of international trade theorists Avinash Dixit Gene Grossman and Paul Krugman 40 The theory of strategic trade provides a rationale for nations to use protectionist measures for subsidies to particular industries and for other forms of industrial policy to provide domestic firms with a deci sive advantage in both home and world markets Favored and pro tected firms can take advantage of increasing returns cumulative pro cesses and the positive feedbacks associated with path dependence to increase their competitiveness in global markets The significance of strategic trade theory can be appreciated through consideration of the fundamental differences between perfect and imperfect competition In those sectors where there is perfect competition ie most of the economy the behavior of one small firm cannot change the rules of the game as it is too small to make a difference This means that a small firm could not gain advantage through strategic behavior However if unit costs in certain industries continue to fall as output increases output will expand and the num ber of firms in the market will decrease Economies of scale in an industry mean that the market will support only one or just a few large firms that is such an industry will become oligopolistic as hap pened in the automobile and computer sectors Thus the market will 39 For an important collection of articles on imperfect competition and other aspects of these matters see Gene M Grossman ed Imperfect Competition and International Trade Cambridge MIT Press 1992 40 James A Brander and Barbara J Spencer International RD Rivalry and Indus trial Strategy Review of Economic Studies 50 no 163 October 1983 70722 An excellent discussion of these theoretical developments is in Paul R Krugman ed Stra tegic Trade Policy and the New International Economics Cambridge MIT Press 1986 123 C H A P T E R F I V E eventually be dominated by only a few firms and this means that their behavior can make a difference and alter the decisions of other firms If there is imperfect or oligopolistic competition in particular economic sectors then monopoly rents or abnormally high profits can exist in that sector and these rents or superprofits can be cap tured by a few firms or even by just one firm 41 The central idea of the new strategic trade theory STT is that firms and governments can behave strategically in imperfect global markets and thereby improve a countrys balance of trade and na tional welfare It assumes that some markets are characterized by im perfect or oligopolistic competition and that this situation can create a strategic environment in which there is only a small number of players Oligopolistic firms can and do consciously choose a course of action that anticipates the behavior of their competitors If success ful this enables them to capture a much larger portion of the market than would be possible under conditions of perfect competition Two of the most important strategies used to increase a firms longterm domination of an oligopolistic market are dumping selling below cost to drive out competitors in the product area and preemption making huge investments in productive capacity to deter others from entering the market Imperfect or oligopolisitc competition is most likely to occur in certain hightech industries characterized by economies of scale and learning by doing These include the aerospace advanced materials computer and semiconductor and biochemical industries these tech nologies of course are identified by all governments as the com manding heights of the information economy Most of them are dual technologies since they are of particular importance both to military weaponry and to economic competitiveness Therefore many nations consider it essential for both commercial and security reasons to take actions that will ensure that they have as strong a capability as possible in such technologies The device of preclusive investment provides an example of the application of strategic trade theory in such a situation investment by a domestic firm in a protected home market can give the firm an overwhelmingly competitive position within that economy a position that can deter investment by other countries in that industrial sector Government policies may provide a national firm with decisive ad vantages in global markets indeed Henry Rosovsky and other econo mists have argued that the strategy of import protection in order to 41 A monopoly rent is an excess return on a resource 124 N E W E C O N O M I C T H E O R I E S export accounts in part for Japanese industrial success in the decades after World War II 42 STT implies that a government can assist a firm to establish a monopolistic or oligopolistic position in world markets For example in a market capable of sustaining only a limited number of producers a state subsidy to a domestic firm may deter foreign firms from entering the home or even foreign markets and thereby confer on subsidized firms a dominant or monopolistic position Vari ous strategic trade tactics have become important in the efforts of national governments to influence the location of industry worldwide STT clearly implies that governments should assist national firms in order to generate positive externalities that is technological spillo vers and also to shift profits from foreign firms to national firms 43 Economists have long appreciated that a nation with sufficient market power could impose an optimum tariff and thereby shift the terms of trade in its favor 44 By restricting imports and decreasing the demand for a product a large economy may be able to cause the price of the imported good to fall STT however goes much farther than opti mum tariff theory in its recognition of a nations ability to intervene effectively in trade matters and thus to gain disproportionately A governments decision to support a domestic firms plans to increase its productive capabilities preemption or to signal an intention to build excess productive capacity is an example of a strategic trade policy By using a direct subsidy to a firm or by giving outright pro tection to a domestic industry the government might deter foreign firms from entering a particular industrial sector Since a minimum scale of production is necessary to achieve efficiency especially in many hightech industries the advantage of being first firstmover advantage encourages a strategy of preemptive investment Thus government intervention through preemption or first strike be comes especially important in certain industrial sectors The new strategic trade theory departs from conventional trade theory in its assumption that certain economic sectors are more im portant than others for the overall economy and therefore warrant government support The manufacturing industries for example are considered more valuable than service industries because manufactur ing is characterized by higher rates of productivity growth many be 42 Henry Rosovsky Trade Japan and the Year 2000 New York Times 6 Septem ber 1985 Sec 1 43 A frequently cited example is Airbus an aircraft developed by a BritishFrench consortium 44 An optimum tariff is one that improves a countrys terms of trade to the detriment of its trading partners 125 C H A P T E R F I V E lieve that manufacturing also produces higher profits higher value added and higher wages Some economic sectors especially hightech industries such as computers semiconductors and information pro cessing are particularly important because they generate spillovers and other positive externalities that benefit the entire economy Be cause a new technology in one sector may have indirect benefits for firms in another sector firms that do extensive research and develop ment produce benefits that are valuable to many others Indeed a strategic industry may be defined as one that gives external benefits to the rest of the economy However because firms may not be able to capture or appropriate the results of their research and develop ment activities many will underinvest in these activities Proponents of STT argue that such a market failure indicates that firms should be assisted through direct subsidy or import protection particularly in hightech industries that frequently raise the skill level of the labor force and thus increase human capital If as the proponents of strate gic trade believe such special industries exist then free trade is not optimal and government intervention in trade matters can increase national welfare Strategic trade theory has become a highly controversial subject within the economics profession Some critics argue that it is a clever flawed and pernicious idea that gives aid and comfort to proponents of trade protection Others agree with this negative assessment but also make the point that the theory itself adds nothing really new to already discredited arguments favoring trade protection Perhaps in response to severe denunciations of strategic trade theory by leading mainstream economists some of the earliest and strongest proponents of STT have moderated their initial enthusiasm Many economists consider it to be merely an intellectual game with no relevance to the real world of trade policy Despite these criticisms and recantations however STT has had an important impact on government policy and has undoubtedly been a factor in the slowdown in the growth of world trade The neoclassical critique of strategic trade policy is that all indus tries at least theoretically are created equal no economic sector is intrinsically more valuable than any other in terms of higher value added higher wages and so forth The rate of productivity growth of an economic sector is considered the only real measure of its value and of its contribution to the nations longterm economic welfare A nation therefore should specialize in those economic sectors where high rates of productivity growth exist and where it has a compara tive advantage This sentiment was expressed in an oftenemployed 126 N E W E C O N O M I C T H E O R I E S statement attributed to Michael Boskin chair of the Council of Eco nomic Advisors in the Bush Administration 19891993 that chips are chips and that it is unimportant whether an economy produces one type of chip or the other If a nation has a comparative advantage in potato chips but not in computer chips then it should export the former and import the latter Moreover even if some economic activi ties may be intrinsically more valuable than others critics of strategic trade policy argue that governments are incapable of picking winners and that any efforts to do so are very likely to be captured by special interests Favoring one sector the critics charge would of necessity divert scarce resources and harm other sectors that might be even more valuable to the economy over the long term Finally the critics charge that subsidies and trade protection will only lead to foreign retaliation and then everyone will lose What can be concluded about strategic trade theory and the indus trial policy to which it provides intellectual support The argument that shifting profits from one economy to another can occur has nei ther been proved nor disproved it is quite difficult to assess whether or not government intervention in oligopolistic markets actually works because economists lack reliable models of how oligopolists behave However the positive externalities argument for strategic trade policy and the arguments for the related industrial policy have support in the economics literature Even though empirical evidence for the success of industrial policy is admittedly mixed government support for particular industrial sectors has frequently been very suc cessful in creating technologies in sectors that do spill over into the rest of the economy Most importantly there is strong evidence that government support for R D has a very high payoff for the entire economy Governments around the world certainly believe that sup port for hightech industries produces a high economic return over the long term Conclusion The new economic theories significantly enhance our understanding of the dynamics of the world economy and of the fundamental issues of international political economy regarding distribution of economic outcomes states efforts to retain their national autonomy and con flict among states over the nature of international regimes The pro cess of economic growth the concentration of economic activities in particular locations and the diffusion of economic growth and eco nomic activities to new regions are fundamental elements in the evo 127 C H A P T E R F I V E lution of the world economy Although market forces are central to these processes such powerful actors as states and multinational firms constantly attempt to shape markets in ways that advance their own national or corporate interests The new economic theories have led to recognition that interactions among economictechnological forces and powerful actors lead to shifts in the global distribution of economic activities changes in comparative advantage and trading patterns among national economies and ultimately transformations in the international balance of economic and military power 128 CHAPTER SIX The Political Significance of the New Economic Theories T HE NEW economic theories have a number of significant implica tions for analysis of the world economy Even though all three theories remain highly controversial within the economics profession they nevertheless provide important insights into the nature and dy namics of international economic affairs and they reinforce the state centric interpretation of this book In addition to emphasizing the central role of national governments in economic affairs the theories emphasize the crucial nature of oligopolistic competition and the im portance of technological innovation as determinants of international economic affairs National Governments and Domestic Economies Although every actor within the modern economywhether a corpo ration an interest group or whateverattempts to influence that economy national governments and their policies are by far the most important determinants of the rules and institutions governing the market Despite increasing globalization of economic activities most such activity still takes place within the borders of individual states Each state establishes limits that determine the movement of goods and other factors into and out of its economy and through their laws policies and numerous interventions in the economy governments attempt to manipulate and influence the market to benefit their own citizens or at least some of their citizens and to promote the national interests of that country Every state some more than others at tempts to use its power to influence market outcomes The new theories call attention to the importance of national gov ernments and domestic economies within the world economy 1 They 1 The theories complement a similar change in scholarship in the field of interna tional political economy where the role of domestic factors has been given much greater attention in recent scholarship A pioneering study on the interaction of domes tic and international matters is Peter Gourevitch Politics in Hard Times Comparative Responses to International Economic Crises Ithaca Cornell University Press 1986 An important analysis of the impact of domestic affairs on the international economy is Helen V Milner Interests Institutions and Information Domestic Politics and In ternational Relations Princeton Princeton University Press 1997 129 C H A P T E R S I X help explain continuing government intervention in the economy de spite the apparent triumph of neoliberalism and increasing globaliza tion In a world where economic growth the geographic location of industry and comparative advantage are frequently produced by ar bitrary decisions and cumulative processes national governments have an almost overwhelming incentive to intervene in their domestic economies Through industrial strategic and other interventionist policies every nation to one degree or another does attempt to affect the international division of labor There is growing concern within nationstates about which countries produce what and about the lo cation of hightech jobs and industries this makes it unlikely that such crucial matters will be left solely to the interplay of market forces National governments repeatedly attempt to use their political power and their position in the international political system to in fluence the international division of economic specialization as much as possible National leaders are reluctant to leave economic outcomes entirely up to market forces This is reflected in the considerable differences among national economies regarding the relative importance of the state and the market in national economic structures and outcomes Economic structures and institutions constitute what Nobel Laureate Douglass C North has called the incentive structure of a society and are powerful determinants of economic performance 2 Domestic structures also affect the interactions among national economies and between national and international economic affairs I shall use the term national system of political economy to refer to domestic structures and institutions that influence economic activi ties The principal purposes of every national economy shape the de fining characteristics of each system these purposes may range from promotion of consumer welfare to creation and expansion of national power The role of the state in the economy is a particularly impor tant aspect of each national system the differences among market economies range from the generally laissezfaire noninterventionist stance of the United States government to the central role of the Japa nese state in management of the economy Yet a third feature of a political economy is found in the mechanisms of corporate gover nance and private business practices here again the fragmented American business structure contrasts dramatically with the Japanese system of tightly integrated industrial groupings the keiretsu The national system of innovation is another important aspect of a 2 Douglass C North Economic Performance Through Time American Economic Review 84 no 3 June 1994 359 130 S I G N I F I C A N C E O F N E W T H E O R I E S particular nations political economy When one speaks of a major technological advance or of a technological revolution much more than nuts and bolts is involved Many significant developments in technology involve a transformation in the organization of produc tion and of the broader sociopolitical relationships in an economy 3 Many important aspects of society must be changed in order to de velop or take advantage of new technologies or production possibili ties Indeed some writers use the term technoeconomic paradigm to designate the whole range of economic and institutional transfor mations associated with a particular technological change 4 Successive epochs of technological advance have entailed major transformations in economic behavior and in industrial organization In todays digital or information age the world economy is again experiencing a pro cess of creative destruction from which new economic winners and losers will emerge a process aptly described by Joseph Schumpeter as the dynamics of capitalism The new growth theory implies that political economic and other institutionsfrom governments to universities to corporationscan either hinder or facilitate technical advance its adoption and resul tant longterm economic growth While neoclassical economics main tains that free markets in themselves produce efficient outcomes the new growth theory suggests that national and international economic structures and institutions are major determinants of technological developments and economic growth In fact long before Paul Romer and Robert Lucas set forth the new growth theory a number of econ omists and political economists had conducted pioneering work on the determinants of innovative activities and the diffusion of technical knowledge in the production process Christopher Freeman Richard Nelson and Keith Pavitt are among the most important contributors to an understanding of the resulting national systems of innovation Nathan Rosenberg and L Birdzell Jr have emphasized the crucial importance of the national system of innovation to technological progress in How the West Grew Rich The Economic Transformation of the Industrial World 5 They demonstrate that the economic growth 3 For example Japans innovation of lean production was greatly facilitated by important aspects of the Japanese political economy such as lifetime employment longterm planning by both Japanese corporations and government and the domina tion of the economy by large industrial groupings keiretsu 4 Giovanni Dosi Christopher Freeman Richard Nelson Gerald Silverberg and Luc Soete eds Technical Change and Economic Theory London Pinter 1988 5 Nathan Rosenberg and L E Birdzell Jr How the West Grew Rich The Economic Transformation of the Industrial World New York Basic Books 1986 131 C H A P T E R S I X and the technological success of the West have been due primarily to institutional innovations the unique economic political and other institutions that have characterized the modern West have greatly fa cilitated technological advance capital accumulation and rapid eco nomic growth It was Rosenberg and Birdzell point out the freedom of individual entrepreneurs to experiment with novel institutions and economic arrangements that differentiated the West from other civili zations and this freedom has been vital to the Wests enormous eco nomic success Economic freedom created a powerful incentive for entrepreneurs to innovate invest and accumulate wealth Even though the modern state has been central to development of the national system of political economy and technological innova tion the states role in fostering economic growth and international competitiveness has been largely neglected by neoclassical economics The emphasis in neoclassical growth theory on factor accumulation is indeed appropriate but it is only a first approximation to an expla nation of the causes of a nations growth A particular societys pos session of an institutional framework or national system of political economy that facilitates factor accumulation technological innova tion and economic growth is crucial to its economic success Those societies that adapt themselves to the requirements of economic growth and technological innovation in a particular epoch become the economic leaders of that epoch and societies that do not or can not adjust to such requirements fall behind Oligopoly and Power in Economic Outcomes The economic universe of the new theories is populated by a few important economic actors and characterized by imperfect or oligop olistic competition 6 In an oligopolistic market power and strategy strongly affect economic outcomes consequently many international markets function differently from the predictions of conventional neoclassical economics In the world of oligopolistic competition powerful players can and frequently do use their market power to alter and manipulate the terms of exchange 7 Indeed powerful firms are frequently pricesetters rather than pricetakers In the neo 6 The significance of oligopolistic competition for economic theory is discussed in John R Hicks The Crisis in Keynesian Economics Oxford Basil Blackwell 1974 2325 7 A collection of articles on the neglect of power in economic analysis is in Kurt W Rothschild ed Power in Economics Selected Readings Harmondsworth UK Pen guin Books 1971 132 S I G N I F I C A N C E O F N E W T H E O R I E S classical world of perfect competition the selfregulating market reigns and every economic situation has a single equilibrium solution In an oligopolistic market there are many possible rational economic outcomes and power strategy and guile are important determinants of each economic outcome Oligopolies profoundly change the nature and functioning of markets As an old taunt in the economics profes sion says With oligopoly anything can happen 8 Economists are obviously fully aware of the nature and importance of oligopolistic competition based on economies of scale Alfred Mar shall himself was cognizant of oligopoly but rejected its significance perhaps because of its implications that increasing returns and hence oligopoly would make it theoretically possible for just one or a few firms to dominate an economy As time has passed the subject of oligopoly has been taken more seriously and research in the field of industrial organization on oligopolistic markets has greatly extended understanding of the ways in which oligopolistic markets work Yet it makes economists quite uncomfortable to recognize that oligopolies do exist 9 The negative attitude of most economists toward the impli cations for economic analysis of oligopoly and economies of scale is conveyed in John Hickss comment that increasing returns result in the wreckage of the greater part of economic theory 10 Clearly there is good reason for economists to find oligopoly and imperfect competition distasteful However in political economy oligopoly and imperfect competition are central concerns The world of oligopolistic competition is best comprehended through application of the theory of games or simply game theory set forth initially by John von Neumann and Oscar Morgenstern in their classic study The Theory of Games and Economic Behavior 1944 11 Game theory has become an extraordinarily complex and 8 John Sutton Sunk Costs and Market Structure Price Competition Advertising and the Evolution of Concentration Cambridge MIT Press 1991 xiii 9 For example one important line of inquiry that regarding contestable markets appears to be motivated at least in part by a desire to mute the importance of oligop oly by suggesting that under certain conditions oligopolistic markets behave just like competitive markets William J Baumol Determinants of Industry Structure and Contestable Market Theory in David Greenaway Michael Bleaney and Ian Stewart eds Companion to Contemporary Economic Thought London Routledge 1991 Chapter 24 and William J Baumol John C Panzar and Robert Willig with contribu tions by Elizabeth E Bailey Dietrich Fischer and Herman Q Quirmback Contestable Markets and the Theory of Industrial Structure New York Harcourt Brace Jovanov ich 1982 10 John Hicks quoted in W Brian Arthur Increasing Returns and the New World of Business Harvard Business Review JulyAugust 1996 100109 11 John von Neumann and Oskar Morgenstern The Theory of Games and Economic Behavior Princeton Princeton University Press 1944 133 C H A P T E R S I X esoteric subject but stated as simply as possible the theory of games attempts to predict or explain outcomes of human interactions where the players are few in number and each player has a choice of alter native courses of action or strategies Each individuals strategy is based in part on what that individual believes the strategy or strate gies of the other player or players might be Thus game theory ana lyzes situations characterized by strategic uncertainty and interdepen dent decisionmaking In other words I think that he thinks that I think ad infinitum According to game theory each individual player chooses whatever strategy clearly maximizes gains or minimizes losses The outcome of the game could be either losses or wins for either one or both of the players 12 While in some cases the outcome of a strategic game can be predicted easily this is not always the case In a Nash equilibrium situation the outcome may be predictable Such a situation is defined as an array of strategies from which no player has an incentive to deviate 13 In a Nash equilibrium where one array of strategic choices unquestionably dominates and is preferred by each player over all other possibilities there can be only one outcome that will be satisfac tory for both players In other words in such situations oligopolistic competition may be indistinguishable from perfect competition However the real world of oligopoly is generally characterized by many situations in which a number of Nash equilibria are possible This means that game theory is of little use in describing or predicting business behavior in situations of mutual interdependence The possibility of multiple equilibria has profound implications for both economics and political economy Many if not most strategic situations in which firms and states find themselves do have many feasible equilibrium points or in the jargon of the field are said to have multiequilibria 14 Instead of one obviously best array of strat egies for both players there are several possible arrays In fact there can be an infinite number of equilibria that promise to each cooperat ing player higher returns than would result from noncooperative be havior In such situations it is difficult and perhaps impossible to determine which array of strategies will be selected by the players Thus even in the case of cooperative players it may be difficult to achieve a mutually satisfactory solution 12 The essence of game theory is discussed in Chapter 4 13 David M Kreps Game Theory and Economic Modeling Oxford Clarendon Press 1990 28 14 James D Morrow Game Theory for Political Scientists Princeton Princeton Uni versity Press 1994 306 134 S I G N I F I C A N C E O F N E W T H E O R I E S Regulations governing the market can significantly affect both the strategies available to market participants and also which Nash equi librium will be chosen Therefore the rules or regimes can be or are important determinants of the outcome of economic activities 15 Al though liberals would argue that the rules and regimes can result from cooperative processes more powerful actors frequently impose rules or regimes on other players in the market Since the rules and institutions governing economic activities may reflect the interests of the powerful actors market outcomes are profoundly affected by po litical institutional and other noneconomic factors this is a subject central to the study of international political economy Technological Innovation All the new theories of growth economic location and strategic trade accord an increasingly important role to technological change in de termining the nature and dynamics of the world economy Even though technological progress has always been acknowledged as an important factor in economic affairs technologys scale ubiquitous character and rapid rate of advance are now reshaping every aspect of social economic and political affairs As the twentyfirst century begins technological advances in computers and telecommunications are forcing nations to make major adjustments in their policies and economic structures As we have already observed technology has created a fluid world of scale economies and imperfect competition in which trade patterns the location of economic activities and growth rates are more arbitrary and dependent than in the past on the strategies of private firms and the policies of national govern ments The increased importance of technological innovation in eco nomic affairs has resulted in the following changes Technological Developments and International Competitiveness Electronicsbased design manufacturing and distribution have greatly reduced the time lapse between the innovation of a new product and its production and marketing and this has facilitated rapid flexible response to changes in demand 16 Consequently product diversifica tion has increased and such activities as design distribution and ser vice have gained importance as factors in competition Moreover the 15 Kreps Game Theory and Economic Modeling 182 16 This discussion is based largely on Carl Dahlman The Third Industrial Revolu tion Trends and Implications for Developing Countries April 1992 unpublished 135 C H A P T E R S I X increased importance of these nonmanufacturing activities means that the importance of production costs in determining total costs has de creased the result is that lowcost producers can lose some of their prior competitive advantage Inputs of new materials and resource saving processes also decrease the importance of traditional commod ities in international trade reduce commodity prices and thus harm commodity producers around the world including in the United States Organization of Production and Technological Innovation The world economy is experiencing another phase of the industrial revolution that began in the latter part of the eighteenth century The first phase based on iron and steam power was characterized by the rise of the factory system these developments took place in Great Britain and led to the industrial and international preeminence of that nation The second phase beginning in the latter part of the nine teenth century and based on steel petroleum chemicals electricity and the internal combustion engine occurred in the United States and to a lesser extent in Germany This phase reached its highest development with the advent of the assembly line and mass produc tion labeled Fordism by many writers Once again the technolog ical leader or leaders became the most powerful nations in the world And as in the earlier phases of the industrial revolution the dominant industrial nation used its power to reshape world affairs in its own economic and political interests Furthermore the economic expansion of the technological leader through trade and foreign in vestment imposed on other economies the choice of either adopting the new production methods or retreating behind protective barriers and inevitably falling behind in global economic competition Beginning in the 1970s Japanese firms captured international lead ership in one industrial sector after another due in large part to their implementation of lean production techniques 17 Various techniques associated with lean productionintroduction of quality circles reli ance on justintime inventories kanban that save resources and computerized automationbecame central to the production process in Japan these highly efficient techniques pioneered at Toyota and associated with the technological and organizational revolution dif fused rapidly throughout Japanese industry Later these techniques 17 The story of lean production and its advantages is told in James P Womack Daniel T Jones and Daniel Roos The Machine that Changed the World New York Rawson Associates 1990 136 S I G N I F I C A N C E O F N E W T H E O R I E S spread to other countries but Japanese industry with its ability to keep production costs low and the quality of its products high and to shift product mix much more rapidly than its competitors took a decisive lead in manufacturing in many hightech and other sectors Indeed Japanese superiority in manufacturing processes rather than in product innovation has been the key to Japans outstanding export success Even though many of Japans most successful exports had been invented in the United States Japan triumphed in manufacturing these products in high volume at low cost and with superior quality After several years however as the Japanese system of lean produc tion diffused to other countries the overwhelming Japanese produc tive advantage decreased 18 Indeed during the 1990s American cor porations through downsizing heavy investments in computers and development of new enterprises regained much of the competitiveness they had lost in the mid1980s Globalization Intensified Competition and Transnational Alliances Many developments in the 1990s increased the globalization of the world economy and also intensified international competition in a number of ways Reduced transportation and communication costs contributed to growing globalization in the areas of trade invest ment and production Gigantic multinational corporations became even more central to the management of trade and the organization of production around the world and intrafirm or managed trade rather than armslength or marketbased transactions expanded to a much larger portion of international trade Growing costs for re search and development as well as the increasing importance of scale economies and the need for market access caused more and more firms to enter international markets to capture the returns on their investments The everexpanding scope of modern science and tech nology and the compression of time between innovation and commer cialization provided yet another impetus for intercorporate alliances Learning that no individual firm nor even any single country could take a commanding lead in every industry more and more firms be gan to seek partners in other countries Technological Developments and the International Division of Labor Technological developments affect significantly the comparative ad vantage of developed and developing countries the impact is particu 18 David J Jeremy ed The Transfer of International Technology Europe Japan and the USA in the Twentieth Century London Edward Elgar 1992 137 C H A P T E R S I X larly notable in the rapid advances of the Pacific Asian electronics industry in the 1980s and early 1990s where the effects of technolog ical developments changed the international division of labor In the final decades of the twentieth century the developed countries espe cially the United States were becoming service economies or postin dustrial societies based on the creation processing and distribution of information To speak of the United States as a service economy does not mean as many Americans feared during the late 1980s that the United States was becoming a nation of hamburger flippers nor does it mean that services displace production of consumer and other types of goods The advent of the service economy means that such services as informationbased services are a growing input into the production of hard goods these inputs make it possible to produce more and higher quality goods The nature of manufacturing is changing and reducing employment in the traditional manufacturing sector at the same time that the volume of manufacturing output is increasing 19 In the late nineteenth century a similar transition oc curred as the agriculturebased society shifted to a manufacturing based society and industrialization transformed food production At the same time that the advanced industrial countries are becom ing serviceoriented economies more traditional manufacturing is moving to the less developed countries of Pacific Asia and to a lesser extent to other parts of the world previously known as the Third World Many developing nations shifted by the end of the century from being primarily commodity exporters to becoming exporters of manufactured goods Unfortunately however this development was accompanied by increasing polarization between those rapidly indus trializing economies that could take advantage of ongoing technologi cal changes and the large majority of less developed countries that for one reason or another were unable to adjust to the technological revolution Restricted Access to Leading Technology The new theories differ from neoclassical theory in the extent to which they assume that technological innovation can be appropriated or monopolized by an innovator Neoclassical economics assumes that technology is a public good equally available to all firms that is that technical knowledge cannot easily be monopolized Every firm 19 Geza Feketskuty International Trade in Services An Overview and Blueprint for Negotiations Cambridge Mass An American Enterprise InstituteBallinger Publica tion 1988 138 S I G N I F I C A N C E O F N E W T H E O R I E S regardless of its size nationality or other features is believed to have an equal opportunity to appropriate and exploit the fruits of scientific and technical advance around the world Thus when a firm makes an investment decision the neoclassical assumption is that it can in corporate stateoftheart technology in its new plant and thereby be competitive in world markets The new growth location and trade theories assume to the con trary that technology can be and is being at least temporarily appro priated and monopolized by its innovators Private firms and national governments can and do attempt to slow down the international dif fusion of the most advanced technologies at a moment when achiev ing and maintaining control of technology and knowledge have be come more and more important as factors in economic growth and international competitiveness Thus at the beginning of the twenty first century the technological leaders Japan the United States and Western Europe attempt to restrict transmission of their most ad vanced technologies to foreign competitors and to protect their intel lectual property rights especially from the encroachment of develop ing countries Although an effort to safeguard intellectual property rights against piracy is proper in most cases such efforts can lead to technonationalism and even denial of important medical technology to poor countries 20 Technological Leapfrogging The new growth theory is based on the assumption that technological change is generally incremental within a wellestablished technologi cal paradigm and that an oligopolistic firm can expect to maintain its lead over its rivals through continuous investment in established technology This theory also suggests that technological leapfrogging can sometimes explain drastic reversals among firms and nations in their economic fortune and relative position thus occasionally trans forming the hierarchy of power and the structure of the international system From time to time one economy suddenly moves to a higher stage of technological development and productive efficiency Such technological leapfrogging especially when major powers are in volved can have profound and disturbing consequences for interna tional economic and political affairs 21 The new growth theory may 20 Sylvia Ostry and Richard R Nelson TechnoNationalism and TechnoGlobalism Conflict and Cooperation Washington DC Brookings Institution 1995 21 Elise S Brezis Paul R Krugman and Daniel Tsiddon Leapfrogging in Interna tional Competition A Theory of Cycles in National Technological Leadership Amer ican Economic Review 83 no 5 December 1993 121119 139 C H A P T E R S I X contribute not only to an understanding of the rise and decline of nations but also to improved comprehension of the international po litical conflicts to which shifts in international status frequently give rise If technological advance is revolutionary a technological leader may suddenly find itself at a decisive disadvantage and may even need to start anew and make substantial investments in the new technol ogy Whereas a technological leader with high wages and large invest ments in stateoftheart technologies may have little or no incentive to take advantage of a newer revolutionary technology a more tech nologically backward economy with no vested interest in the pre viously established technology and with cheaper labor and an under valued currency is likely to view the new technology as a promising means to leap ahead of the leader In times of normal incremental technological change increasing returns to scale generally favor eco nomic leaders However a new invention or a major technological breakthrough may favor the interests of a rising economy while disad vantaging those economic leaders who pay high wages and as Mancur Olson has demonstrated are also strongly influenced by ves ted interests that oppose adoption of new ideas 22 In this way success in one stage of economic development may create barriers to success in the next stage Intensified Competition for Technological Leadership Historically there has been a high correlation among technological economic and political leadership The rise of particular nations to global preeminencefor example Great Britain the United States Germany and Japanresulted from their ability to take advantage of the first and second Industrial Revolutions As in those earlier revo lutions the latest technological revolution has given rise to intensified competition among national economies for leadership In the late nineteenth century the great powers struggled with one another over the commanding heights of mass production At the close of the twen tieth century and in the beginning of the twentyfirst century the bat tleground has been located among the hightech industries of the computer and the information economies This has produced an in tensifying competition among the great economic powers for global supremacy in these technologies and consequently for dominant po litical power in the future 22 Mancur Olson Jr The Rise and Decline of Nations Economic Growth Stagfla tion and Social Rigidities New Haven Yale University Press 1982 140 S I G N I F I C A N C E O F N E W T H E O R I E S Technological developments available at the turn of the century hold great promise that all economies could eventually benefit These new technologies are so central to economic competitiveness and na tional power that the struggle to determine which nations will lead and which will follow in development and exploitation of these revo lutionary technologies has been intensifying Although recognition of the importance of the technologies has unleashed a competitive strug gle among states for technological supremacy it is highly unlikely that any nation will be able in the early years of the twentyfirst century to achieve the commanding technological leads that Great Britain and the United States enjoyed in the nineteenth and twentieth centuries The scope and expense of modern science and technology are simply too great for any one nation to acquire a monopoly posi tion in every hightech sector Nevertheless the competition will be fierce because control over what have been called the nerve centers of the twentyfirst century is at stake in this struggle Convergent and Divergent Economic Growth The world economy portrayed by the new economic theories is char acterized by both divergent and convergent economic growth among national economies and different regions within individual national economies Despite the optimistic predictions flowing from the con vergence theory of mainstream neoclassical economics the growth process within and among national economies remains highly uneven Although convergence has been taking place among the industrialized countries throughout the postWorld War II era few developing economies have converged with the developed economies despite the considerable progress that some have experienced An important study by Robert Barro and Xavier Martin found that the prediction that convergence between rich and poor would occur has not been fulfilled in fact the growth rates of many countries are diverging from one another 23 Government policies that encourage private en trepreneurship and national economic efficiency are important in de termining that convergence rather than divergence will take place 23 Robert J Barro and XavierMartin Convergence Across States and Regions Washington Brookings Institution Brookings Papers on Economic Activity 1 1991 10758 These negative findings regarding convergence are supported by Mauruce Ob stfeld and Kenneth Rogoff Foundations of International Marcroeconomics Cam bridge MIT Press 1996 454 141 C H A P T E R S I X The low capacity of the societies in less developed countries to ab sorb the knowledge required for economic development has proved to be a particularly significant deficiency As I have already pointed out the availability of human capital and the ability to use knowledge are the most important determinants of economic development Edu cational institutional andor some other factors may provide reasons for the weakness of less developed countries in meeting the require ments for economic development 24 As Moses Abramovitz has pointed out convergence occurs only when national economies share a similar social capacity He was referring to the institutional and human components of a society that develop only slowly through educational and organizational responses to technological opportu nity 25 Unfortunately few less developed countries possess such a ca pacity Differences in the level of social capacity among national econo mies leads to an international coreperiphery structure in which strong concentrations of economic wealth and economic activities the core economies coexist with weaker or peripheral economies Emergence of core economies and slower development of other econ omies results in an uneven evolution of the international economy In the language of economics economic development around the world is lumpy as development clusters in one region of the globe or another While some nations and regions develop and become impor tant components of the world economy others remain stagnant or develop more slowly Over time however new regional concentra tions of economic activities arise and older developed regions decline at least in relative terms The coreperiphery structure is held together by mutual depen dence trade investment and other economic activities bind the core economy and peripheral economies Yet in almost all cases the pe riphery is much more dependent on the core than vice versa The core is the peripherys major source of capital and investment as well as being a large market for the exports of the periphery The periphery is primarily a source of commodities food raw materials etc lower valued exports and in some cases workers In the language of 24 Luc Soete and Bart Verspagen Technology and Growth The Complex Dynamics of Catching Up Falling Behind and Taking Over in Adam Szirmai Bart Van Ark and Dirk Pilat eds Explaining Economic Growth Amsterdam North Holland 1993 8 25 Moses Abramovitz first set forth his notion of social capacity in Thinking About Growth and Other Essays on Economic Growth Cambridge Cambridge University Press 1989 142 S I G N I F I C A N C E O F N E W T H E O R I E S Hirschman the core has power over the periphery because a rupture of their ties would be more costly to the latter than the former Keohane and Nye 1977 had much the same point in mind when they distinguished between sensitivity and vulnerability inter dependence 26 The global process of uneven economic development and the exis tence of coreperiphery structures are the result of the interplay of opposed economic forces that successively create and undermine re gional concentrations of industry and economic activity 27 On the one hand are found forces of polarization or agglomeration that promote regional concentration of economic activities These forces include economies of scale the technological and other advantages gained by path dependence and the cumulative process In addition externali ties and the learning experience can give a region a powerful competi tive advantage over other regions For example the ability of entre preneurs within a region to take advantage of local technologies knowledge spillovers and economies of scale will enhance their com petitiveness In addition a region may also possess the advantages of proximity to suppliers and customers and the linkages that develop among firms dealing in intermediate goods 28 Then there are the op posed forces of spread and diffusion The forces of dispersal that lead to development of new core economies include diffusion of technology from developed to industrializing economies the exhaustion of valu able resources increasing labor costs in the cores rising land costs and such other diseconomies as urban congestion and rising taxation Whether the centrifugal forces concentrating economic activities or the centripetal forces dispersing them will prevail in a particular case is virtually impossible to predict as with almost every economic ques tion the answer is It depends It is impossible to know which economies will become core economies or which will be in the periph ery over the long term As Paul R Krugman has pointed out the organization of the world economy with respect to the location of 26 These matters are discussed in Chapter 4 27 Prior to Krugman a number of scholars such as Albert O Hirschman and Gunnar Myrdal made important contributions to the study of the coreperiphery formation These writings are discussed in my book The Political Economy of International Rela tions Princeton Princeton University Press 1987 One important element missing from these earlier analyses and emphasized by Krugman is the role of economies of scale in the formation of core economies A discussion of this earlier literature is Keith Chapman and David Walker Industrial Location Principles and Policies Cambridge Basil Blackwell 1987 28 Anthony J Venables Cities Trade and Economic Development May 1999 unpublished 143 C H A P T E R S I X particular industries the concentration of wealth and economic activi ties in urban centers and core economies and the uneven development of the globe and the unequal distribution of wealth among societies are to a considerable degree functions of chance arbitrariness and historical accident reinforced by increasing returns and cumulative pro cesses 29 Nevertheless several generalizations on the global process of economic development can be extracted from the writings of econo mists on the new economic geography and other recent theories 1 The process of concentration or agglomeration divides the global economy into developed and less developed regions Concentra tion of economic activities is particularly characteristic of manu facturing as firms desire to be close to large markets and to sup pliers of intermediate goods 2 Agglomeration is primarily confined to regions within individual developed economies However as trade and other barriers fall uneven growth and a resulting coreperiphery structure extend across national boundaries Divergent growth rates rather than convergent rates are characteristic of the global economy 3 Economic development takes place sequentially and unevenly as clusters of economic activity spread from industrialized to indus trializing countries While generally contributing to greater understanding of the dy namics of the world economy the above generalizations lack certain key components that a comprehensive analysis should include In the first place Krugmans coreperiphery model overlooks the economic and especially the political implications of that structure for the world economy For example a nation that possesses one or more regional cores with strong industries can achieve an overwhelming economic and competitive superiority over other nations As econo mists point out an economy with a head start in the accumulation of knowledge tends to widen its productivity lead Actually one implica tion of Paul Krugmans coreperiphery formulation is that a hierarchi cal global economic and political structure will be created in which the core economyeconomies possess the most important economic activities and the dependent periphery is where lower valueadded economic activities are located Such a situation inevitably becomes a major source of economic tension and even political conflict 29 Paul R Krugman Geography and Trade Cambridge MIT Press 1991 144 S I G N I F I C A N C E O F N E W T H E O R I E S In the game of international economics one vital national objective is to ensure possession of important core regions and leading indus tries Because a head start is so very important lagging nations are motivated to pursue such trade and industrial policies as subsidies to local businesses and erection of protectionist barriers in order to catch up with or leapfrog over the leading economy Nations desire core regions because they are associated with high wages economic power and national autonomy Almost every government engages in deliberate efforts to erect barriers to protect established industries or provide inducements to attract new industries Policies of economic nationalism attempt to increase the probability that both the centripe tal and centrifugal forces will work toward the nations own advan tage A notable example of such an effort to redistribute industry and other economic activities to a nations own advantage occurred when in the last part of the nineteenth century Canada put into place high trade barriers subsidized a transcontinental railway and took other actions to encourage foreign direct investment and to create an indus trialized united and independent economy This strategy of encour aging diffusion of industry to and within Canada met with consider able success Another significant implication of economic geography is that low ering trade and other economic barriers will lead to economic integra tion across national boundaries and to significant restructuring of na tional economies As integration takes place industry and other economic activities tend to migrate within the enlarged market As displacements occur existing coreperiphery structures will be recon figured and new structures will be formed Increasing economic inter dependence in the world economy or within a regionalized economy such as the European Union or the North American Free Trade Agreement NAFTA will result in many economic activities shifting their geographic location Yet it remains impossible to predict the overall result of this restructuring and whether industry will move to the periphery to take advantage of lower cost labor or will concen trate in the existing regional cores 30 The neoclassical characterization of a smooth evolution of the world economy is patently unrealistic Indeed as convergence among developed and developing economies takes place conflict between 30 Paul R Krugman and Anthony J Venables Integration and the Competitiveness of Peripheral Industries in Christopher Bliss and Jorge Braga De Macedo eds Unity with Diversity in the European Economy The Communitys Southern Frontier New York Cambridge University Press 1996 Chapter 3 145 C H A P T E R S I X them invariably intensifies for several reasons 31 In the first place the rise of a new economic power decreases the relative economic share and international status of the dominant economy A second and closely related effect is that this shift in economic wealth and techno logical capability causes an economy experiencing relative decline to be concerned over its national security And thirdly as the rising power closes the economictechnological gap it competes away the monopoly rents or superprofits of the more advanced economy Un der these circumstances it is not surprising that declining powers have made scapegoats of rising powers and have charged that the latter have played the game unfairly this happened in the late 1980s and early 1990s when Japan seemed to be displacing the United States as the worlds dominant economic power There are several alternative strategies available to a declining eco nomic power The most drastic recourse is to use military power to remove the economic challenge and security threat posed by the rising power fortunately utilization of this option is rare and usually the result of serious political conflicts rather than of merely economic tensions A second option is a retreat into trade protection even though protectionism will most likely accelerate economic decline or an attempt to weaken the rising economy The third and most desir able response available to the challenged country is to take policy initiatives designed to rejuvenate its own flagging economy This strategy of economic adjustment can mean letting the market work andor implementing judicious interventionist policies to shift an economy away from those industries and economic activities in which it is losing comparative advantage and toward those in which it is gaining advantage Frequently a challenged economy pursues a com bination of these strategies As the new theories suggest a government can pursue specific mac roeconomic and microeconomic policies to strengthen its economy It can for example devalue its currency although this choice may temporarily increase the competitiveness of the economy it is at best a shortterm strategy A better strategy would be to take steps to increase the productivity of the economy This can be done through improving market functioning However as the theory of strategic trade and the importance of technology suggest the government can also take more direct actions It is quite clear for example that gov 31 Staffan Burnenstam Linder The Pacific Century Economic and Political Conse quences of AsianPacific Dynamism Stanford Stanford University Press 1986 9094 146 S I G N I F I C A N C E O F N E W T H E O R I E S ernment support for basic scientific and technological R D can produce large economic payoffs In addition the crucial role of skilled labor in economic development and international competition makes it imperative that governments actively promote education and worker training As they respond to the process of uneven growth governments do have choices Although the strategy of economic adjustment is certainly the pref erable response to convergence and to relative economic decline it is frequently the most difficult to carry out As Mancur Olson argued in The Rise and Decline of Nations 1982 the balance of power within an economy tends to favor those groups whose interests lie with the status quo and therefore do not want to pay the costs of adjustment 32 Because they know precisely what they may lose threat ened and entrenched economic sectors frequently put pressure on their governments for protection against the unfair trading and economic practices of rising competitors In the contemporary world a frequent response to convergence and other shifts in the global dis tribution of highly valued economic activities is to undertake or ex pand regional economic and political arrangements such as the Euro pean Union and the North American Free Trade Agreement NAFTA Conclusion The new economic theories and their implications for the world econ omy lead me to conclude that governments and their policies are and will remain of crucial importance for the functioning of the interna tional economy Despite the increasing significance of the market and economic globalization economic outcomes are determined not only by economic forces but also by governments and their policies Yet national societies differ fundamentally in the degree to which their governments play a meaningful role in the economy and in the ways in which they attempt to manage their economies 32 Olson The Rise and Decline of Nations 147 CHAPTER SEVEN National Systems of Political Economy M ANY PROFESSIONAL economists and scholars of international political economy IPE including myself have given insuffi cient attention to the importance of domestic economies to the ways in which the world economy functions Economists regard national economies as dimensionless points while scholars of IPE have fo cused almost exclusively on the international political and economic system While it was never justifiable to neglect the role of domestic factors in the study of international political economy it has become increasingly obvious that the role of domestic economies and the dif ferences among those economies have become significant determi nants of international economic affairs Thus study of the different types of national economies or national systems of political econ omy and their significance for the global economy has become an important aspect of the study of international political economy 1 Several developments in the 1980s increased awareness of the im portance of the differences among national political economies The miserable economic performance of the socialist economies and of most less developed countries led many observers to appreciate the superiority of the market system The extraordinary economic success of Japan and of the industrializing economies of Pacific Asia prior to the 1997 financial crisis led revisionist scholars to declare and others to worry that the capitalist developmental state model provided the best route to economic success International economic conflicts in tensified and led to charges that one country or another was not playing fair and the increasing integration of various national economies with others possessing differing economic structures and business practices increased awareness of the significance of these dif 1 The writings on comparative political economy are quite extensive Examples in clude Peter A Hall Governing the Economy The Politics of State Intervention in Britain and France New York Oxford University Press 1986 and Gunter Heiduk ed Technological Competition and Interdependence The Search for Policy in the United States West Germany and Japan Seattle University of Washington Press 1990 A polemical but interesting work is Michel Albert Capitalism vs Capitalism How Americas Obsession with Individual Achievement and Shortterm Profit Has Led It to the Brink of Collapse New York Four Walls Eight Windows 1993 148 S Y S T E M S O F P O L I T I C A L E C O N O M Y ferences As economic interdependence has progressed national dif ferences have more frequently become the subject of international ne gotiations and a factor in the growing movement toward economic regionalism In the 1980s and 1990s there was some convergence among na tional economies and the differences among them diminished in a number of important respects Nevertheless in the early years of the twentyfirst century fundamental differences among national econo mies remain important This point is especially applicable to the American German and Japanese economies These dominant econo mies not only influence the world economy but they are also arche types for many other economies Whereas the American British and other AngloSaxon economies have much in common the German economy shares many features with the corporatisttype economies of continental Europe and the Japanese economy has in certain re spects provided a model for the developmental capitalist econo mies of Pacific Asia 2 Differences among National Economies While national systems of political economy differ from one another in many important respects differences in the following areas are worthy of particular attention 1 the primary purposes of the eco nomic activity of the nation 2 the role of the state in the economy and 3 the structure of the corporate sector and private business practices Although every modern economy must promote the welfare of its citizens different societies vary in the emphasis given to particu lar objectives those objectives which range from promoting con sumer welfare to pursuit of national power strongly influence and are influenced by such other features of a national economy as the role of the state in the economy and the structure of that economy As for the role of the state in the economy market economies in clude the generally laissezfaire noninterventionist stance of the United States as well as the Japanese states central role in the over all management of the economy And the mechanisms of corporate governance and private business practices also differ the relative ly fragmented American business structure and the Japanese system of tightly integrated industrial groupings the keiretsu contrast dra matically with one another Very different national systems of politi 2 Peter Katzenstein Corporatism and Change Austria Switzerland and the Politics of Industry Ithaca Cornell University Press 1984 149 C H A P T E R S E V E N cal economy result from the variations in the basic components of economies The purpose of economic activity in a particular country largely determines the role of the state in that economy In those liberal socie ties where the welfare of the consumer and the autonomy of the mar ket are emphasized the role of the state tends to be minimal Al though liberal societies obviously differ in the extent to which they do pursue social welfare goals the predominant responsibility of the state in these societies is to correct market failures and provide public goods On the other hand in those societies where more communal or collective purposes prevail the role of the state is much more intru sive and interventionist in the economy Thus the role of such states can range from providing what the Japanese call administrative guidance to maintaining a command economy like that of the for mer Soviet Union The system of corporate governance and private business practices constitutes another important component of a national political econ omy American German and Japanese corporations have differing systems of corporate governance and they organize their economic activities production marketing etc in varying ways For example whereas shareholders stockholders have an important role in the governance of American business banks have played a more impor tant role in both Japan and Germany In addition regarding business practices whereas the largest American firms frequently invest and produce abroad Japanese firms prefer to invest and produce at home The policies of each government have also shaped the nature of busi ness enterprise and business behavior through regulatory industrial and other policies furthermore some national differences in corpo rate structure and business practices as Alfred Chandler has demon strated have evolved largely in response to economic and technologi cal forces 3 The American System of MarketOriented Capitalism The American system of political economy is founded on the premise that the primary purpose of economic activity is to benefit consumers while maximizing wealth creation the distribution of that wealth is of secondary importance Despite numerous exceptions the American economy does approach the neoclassical model of a competitive mar 3 Alfred D Chandler Strategy and Structure Chapters in the History of the Indus trial Enterprise Cambridge MIT Press 1970 150 S Y S T E M S O F P O L I T I C A L E C O N O M Y ket economy in which individuals are assumed to maximize their own private interests utility and business corporations are expected to maximize profits The American model like the neoclassical model rests on the assumption that markets are competitive and that where they are not competitive competition should be promoted through antitrust and other policies Almost any economic activity is permit ted unless explicitly forbidden and the economy is assumed to be open to the outside world unless specifically closed Emphasis on con sumerism and wealth creation results in a powerful proconsumption bias and insensitivity at least when compared with the Japanese and German models to the social welfare impact of economic activities Although Americans pride themselves on their pragmatism the Amer ican economy is based upon the abstract theory of economic science to a greater degree than is any other economy 4 At the same time however the American economy is appropriately characterized as a system of managerial capitalism 5 As Adolf Berle and Gardner Means pointed out in their classic study of American corporations the economy was profoundly transformed by the late nineteenthcentury emergence of huge corporations and the accompa nying shift from a proprietary capitalism to one dominated by large oligopolistic corporations 6 Management was separated from owner ship and the corporate elite virtually became a law unto itself Subse quently with the New Deal of the 1930s the power balance shifted noticeably away from big business when a strong regulatory bureau cracy was established and organized labor was empowered in effect the neoclassical laissezfaire ideal was diluted by the notion that the federal government had a responsibility to promote economic equity and social welfare The economic ideal of a selfregulating economy was further undermined by passage of the Full Employment Act of 1946 and the subsequent acceptance of the Keynesian idea that the federal government has a responsibility to maintain full employment through use of macroeconomic fiscal and monetary policies Al 4 Excellent studies of the American political economy include John L Campbell J Rogers Hollingsworth and Leon N Lindberg eds Governance of the American Econ omy New York Cambridge University Press 1991 Frederic L Pryor Economic Evo lution and Structure The Impact of Complexity on the US Economic System New York Cambridge University Press 1996 and James E Alt and K Alec Crystall Politi cal Economics Berkeley University of California Press 1983 5 This characterization of the American economy is based on William Lazonick Business Organization and the Myth of the Market Economy New York Cambridge University Press 1991 6 Adolf A Berle and Gardner C Means The Modern Corporation and Private Prop erty New York Macmillan 1932 151 C H A P T E R S E V E N though at the opening of the twentyfirst century the federal govern ment retains responsibility for full employment and social welfare a significant retreat from this commitment began with the 1980 election of Ronald Reagan as President of the United States and the triumph of a more conservative economic ideology emphasizing free and un regulated markets Commitment to the welfare of individual consumers and the reali ties of corporate power have resulted in an unresolved tension be tween ideal and reality in American economic life Whereas such consumer advocates as Ralph Nader want a strong role for the gov ernment in the economy to protect the consumer American econo mists and many others react negatively to an activist government be cause of their belief that competition is the best protection for consumers except when there are market failures In addition there has been no persistent sense of business responsibility to society or to individual citizens Japanese corporations have long been committed to the interests of their stakeholders including labor and subcontrac tors and German firms acknowledge their responsibility to society and are more accepting of the welfare state than are American firms This explains why Japanese and German firms are much more reluc tant to shift industrial production to other countries than are their American rivals However over time the balance between the ideal and the reality of the American economy has shifted back and forth In the 1980s the election of Ronald Reagan as President and then his Administrations emphasis on the unfettered market diluted the wel fare ideal of the earlier postWorld War II era Economic Role of the State The role of the American government in the economy is determined not only by the influence of the neoclassical model on American eco nomic thinking but also by fundamental features of the American political system Authority over the economy is divided among the executive legislative and judicial branches of the federal government and between the federal government and the fifty states Whereas the Japanese Ministry of Finance has virtual monopoly power over the Japanese financial system in the United States this responsibility is shared by the Treasury the Federal Reserve and several other power ful and independent federal agencies furthermore all of those agen cies are strongly affected by actions of the legislative and judicial branches of government In addition the fifty states frequently con test the authority of the federal government over economic policy and implement important policies of their own 152 S Y S T E M S O F P O L I T I C A L E C O N O M Y Another restraining influence on the role of the American state in the economy is the tension between the private and public sectors Not only does the adversarial relationship between government and business in the United States make cooperation very difficult but their mutual suspicions are reflected in American politics Whereas political conservatives reject at least in principle any strong role for the state in the economy political liberals are fearful that private business in terests will capture government programs in order to feather their own nests and this frequently produces political stalemate At the same time however the fragmented structure of the American gov ernment and its many points of access make it easier for private inter ests to challenge government actions than it is in some other systems These ideological structural and public versus private aspects of the American political economy have restricted greatly the capacity of the American government to develop a coherent and effective national economic strategy There is a major exception to the generally limited role of the American government in the economy in the area of macroeconomic policymaking However even in this area the responsibility for mac roeconomic policy in actual practice has been divided The Congress and the executive branch are both responsible for fiscal policy but control over monetary policy is vested in the Federal Reserve and the Fed functions largely independently of the rest of the federal government However starting with the fiscal excesses of the Reagan Administration in the early 1980s and accumulation of an immense federal debt the Congress and the executive branch deemphasized fiscal policy and the Federal Reserve with control over monetary policy became the principal manager of the American economy The role of the federal government at the level of microeconomic policy is highly controversial American society assumes that the gov ernment should establish a neutral environment for business and should not involve itself directly in business affairs The primary re sponsibility of the government is believed to be the regulation of the economy provision of public goods and elimination of market fail ures Notable examples are found in antitrust policies regulation of pollution and the safeguarding of public health As Stephen G Breyer and Richard B Stewart point out in their authoritative text on administrative law and regulatory policy the rationale for govern ment intervention in the economy is to correct market failure as iden tified by economists The unregulated market is treated as the norm and advocates of government intervention must prove that such inter vention is sometimes justifiable in order to achieve important public 153 C H A P T E R S E V E N objectives 7 Market failures that may justify an active government role in the economy include monopoly power negative externalities and inadequate consumer information Industrial policy represents the greatest difference between the United States and other economies except for Great Britain another AngloSaxon economy 8 Industrial policy refers to deliberate efforts by a government to determine the structure of the economy through such devices as financial subsidies trade protection or government procurement Industrial policy may take the form either of sectoral policies of benefit to particular industrial or economic sectors or poli cies that benefit particular firms in this way such policies differ from macroeconomic and general policies designed to improve the overall performance of the economy policies such as federal support for edu cation and R D Although Japan has actively promoted sector specific policies throughout the economy the United States has em ployed these policies in just a few areas notably in agriculture and national defense Although firmspecific policies are generally frowned upon in the United States as examples of pork barrel poli tics government policies in support of Chrysler and Harley David son in years when they were threatened were considered successful firmspecific policies However as I shall note below the United States in the 1980s took a major step toward establishing a national industrial policy The rationale or justification for industrial policy and associated interventionist activities is that some industrial sectors are more im portant than others for the overall economy The industries selected are believed to create jobs of higher quality like those in manufactur ing to produce technological or other spillovers externalities for the overall economy and to have a high valueadded These industries are frequently associated with national defense or are believed to pro duce a highly beneficial effect on the rest of the economy the com puter industry and other hightech sectors provide examples of such industries In general however the only justification for an industrial policy considered legitimate in the United States is to overcome a 7 Stephen G Breyer and Richard B Stewart Administrative Law and Regulatory Policy Boston Little Brown 1979 8 The literature on industrial policy is quite extensive A good place to survey the subject is M Donald Hancock John Logue and Bernt Schiller eds Managing Modern Capitalism Industrial Renewal and Workplace Democracy in the United States and Western Europe New York Greenwood Press 1991 An excellent and wideranging discussion of the subject is Keith Cowling and Roger Sugden eds Current Issues in Industrial Economic Strategy New York Manchester University Press 1992 154 S Y S T E M S O F P O L I T I C A L E C O N O M Y market failure In practice most American economists public offi cials and business leaders are strongly opposed to industrial policy Their principal objection is that governments are incapable of picking winners many argue that politicians will support particular industries for political pork barrel reasons rather than for sound economic reasons 9 American economists argue that the structure and distribu tion of industries in the United States should be left entirely to the market This belief is supported by the assumption that all industries are created equal and that there are no strategic sectors Nevertheless despite the arguments against having an industrial policy in America such policies have developed in the areas of agriculture national secu rity and research and development Corporate Governance and Private Business Practices The American system of corporate governance and industrial struc ture parallels its political system The governance and organization of American business are characterized by fragmentation and an overall lack of policy coordination Indeed the strong American antitrust and competition policies are intended to prevent concentration of cor porate power and direction American business is much more con strained in its ability to share business information to pool techno logical and other resources and to develop joint strategies than are its rivals Many observers have charged that such restrictions disad vantage American firms in global competition Control of American business is also much more dispersed than in Japan and Germany Although American firms are much more re sponsive to shareholder concerns then are German and Japanese firms the largest shareholders in many of Americas large corpora tions may own just 1 or 2 percent of the stock In Japan ownership of 70 percent or more of the stock frequently resides in a cooperative business grouping called a keiretsu Also industry and finance are more completely separated from one another in the United States and in some instances this has meant higher capital costs than those en joyed by foreign rivals This also contributes to frequent conflicts be tween industry and finance and these conflicts have been detrimental to national policymaking At the national level the National Associ ation of Manufacturers Chamber of Commerce and other business organizations have no role commensurate with that of either the kei 9 A valuable and representative critique of industrial policy is Gene M Grossman Promoting New Industrial Activities A Survey of Recent Arguments and Evidence Princeton Woodrow Wilson School 1989 155 C H A P T E R S E V E N danren the organization representing Japanese big business or the Federation of German Industries Both the Japanese and German or ganizations can speak with a single strong voice and frequently do act on behalf of major business interests A fundamentally different conception of the corporation and its role in society underlies many of these contrasts between shareholder stockholder American capitalism and JapaneseGerman stakeholder capitalism In the American system of shareholder capitalism a firms fundamental purpose is to make profits for its investors or sharehold ers in principle the firm has minimal obligations to employees and or to the communities in which its production facilities are located Moreover in the United States a business corporation is regarded as a commodity that is bought and sold like any other commodity with out regard for the social consequences of such transactions waves of leveraged buyouts and corporate takeovers in the 1980s and 1990s were extreme examples of this mentality In both Japan and Ger many on the other hand the corporation is assumed to have a major responsibility toward its stakeholders workers subcontractors etc and the interests of shareholders are given much less attention than in the American system instead firms are expected to promote larger social objectives Japanese firms are expected to increase the power and independence of the Japanese nation and to promote social harmony Germany also places a high premium on social welfare American law is designed to ensure neutrality and fair play in the competitive market for corporate control In Japan and Germany profitability has been assigned less importance than economic stabil ity Moreover German and Japanese policies are intended to limit hostile and foreign takeovers and to control what Carl Kester has called the global contest for corporate control 10 The Japanese System of Developmental Capitalism G C Allen the distinguished British authority on Japanese economic history tells a story that provides an important insight into Japanese economic psychology At the end of World War II American occupa tion officials advised the Japanese that they should follow the theory of comparative advantage and hence concentrate on laborintensive products in rebuilding their economy Japans economic and political elite however had quite different ideas and would have nothing to 10 W Carl Kester Japanese Takeovers The Global Contest for Corporate Control Boston Harvard Business School Press 1991 156 S Y S T E M S O F P O L I T I C A L E C O N O M Y do with what they considered an American effort to relegate Japan to the low end of the economic and technological spectrum Instead the Japanese Ministry of International Trade and Industry MITI and other agencies of the Japanese economic high command set their sights on making vanquished Japan into the economic and technolog ical equal and perhaps even the superior of the West At the opening of the twentyfirst century this objective has remained the driving force of Japanese society 11 In the Japanese scheme of things the economy is subordinate to the social and political objectives of society As the distinguished Jap anese economist Ryutaro Komiya has written ever since the Meiji Restoration 1868 Japans overriding goals have been making the economy selfsufficient and catching up with the West 12 In the preWorld War II years this ambition meant building a strong army and becoming an industrial power Since its disastrous defeat in World War II however Japan has abandoned militarism and has focused on becoming a powerful industrial and technological nation while also promoting internal social harmony among the Japanese people There has been a concerted effort by the Japanese state to guide the evolution and functioning of their economy in order to pur sue these sociopolitical objectives 13 These political goals have resulted in a national economic policy for Japan best characterized as neomercantilism it involves state as sistance regulation and protection of specific industrial sectors in order to increase their international competitiveness and attain the commanding heights of the global economy This economic objec tive of achieving industrial and technological equality with other countries arose from Japans experience as a late developer and also from its strong sense of economic and political vulnerability Another very important source of this powerful economic drive is the Japanese 11 Among the many important studies of the Japanese economy several should be mentioned Yasusuke Murakami An Anticlassical PoliticalEconomic Analysis A Vi sion for the Next Century ed and trans Kozo Yamamura Stanford Stanford Univer sity Press 1996 is a brilliant interpretation of the distinctive nature of the Japanese economy Takatoshi Ito The Japanese Economy Cambridge MIT Press 1992 is a very useful survey and analysis of the Japanese economy Bai Gao Economic Ideology and Japanese Industrial Policy Developmentalism from 1931 to 1965 Cambridge Cambridge University Press 1997 is an outstanding history and evaluation of Japa nese industrial policy 12 Ryutaro Komiya Industrial Policy in Japan Orlando Fla Academic Press 1988 13 Richard J Samuels Rich Nation Strong Army National Security and the Tech nological Transformation of Japan Ithaca Cornell University Press 1994 157 C H A P T E R S E V E N peoples overwhelming belief in their uniqueness in the superiority of their culture and in their manifest destiny to become a great power Many terms have been used to characterize the distinctive nature of the Japanese system of political economy Shinto capitalism devel opmental state capitalism tribal capitalism collective capitalism wel fare corporatism competitive communism network capitalism com panyism producer capitalism stakeholder capitalism strategic capitalism and perhaps most famously or infamously Japan Inc Each of these labels connotes particularly important elements of the Japanese economic system such as its overwhelming emphasis on economic development the key role of large corporations in the orga nization of the economy and society subordination of the individual to the group primacy of the producer over the consumer and the close cooperation among government business and labor I believe that the term developmental state capitalism best captures the es sence of the system because this characterization conveys the idea that the state must play a central role in national economic develop ment and in the competition with the West Despite the imperative of competition the Japanese frequently sub ordinate pursuit of economic efficiency to social equity and domestic harmony 14 Many aspects of the Japanese economy that puzzle for eigners are a consequence of a powerful commitment to domestic har mony and overregulation of the Japanese economy is motivated in part by a desire to protect the weak and defenseless For example the large redundant staffs in Japanese retail stores developed from an effort to employ many individuals who would otherwise be unem ployed and discontented This situation is also a major reason for the low level of productivity in nonmanufacturing sectors and it ac counts in part for Japans resistance to foreign direct investment by more efficient foreign firms The Japanese system of lifetime employ ment has also been utilized as a means to promote social peace Japa nese firms unlike their American rivals are very reluctant to down size and lay off thousands of employees At the opening of the twentyfirst century however Japans economic problems are causing this situation to change Nevertheless the commitments to political independence and social harmony are major factors in the Japanese states determination to maintain firm control over the economy Economic Role of the State Ever since the 1868 Meiji Restoration the Japanese state has assumed the central role in the economy Following Japans defeat in World 14 Frank Upham Law and Social Change in Postwar Japan Cambridge Harvard University Press 1987 158 S Y S T E M S O F P O L I T I C A L E C O N O M Y War II the ruling tripartite alliance of government bureaucracies the governing Liberal Democratic Party LPD and big business began to pursue vigorously the goal of catching up with the West To this end the elite pursued rapid industrialization through a strategy employing trade protection exportled growth and other policies The Japanese people have supported this extensive interventionist role of the state and believe that the state has a legitimate and important economic function in promoting economic growth and international competi tiveness The government bureaucracy and the private sector with the former frequently taking the lead have consistently worked to gether for the collective good of Japanese society To attain the goal of rapid industrialization the Japanese state sup ported or even created certain social characteristics including an industrious and highly educated workforce In many ways the Japa nese state created todays Japanese society 15 Japans postal savings institution fostered an extraordinarily high savings rate Because of strict capital controls for much of the postwar era the postal service was able while paying depositors just a minimal rate of interest to make these savings available for loans to Japanese firms such finan cial assistance significantly reduced the cost of capital and contributed importantly to the rapid industrialization of the country and to inter national competitiveness The Japanese state has also unfortunately played an important role in supporting social political and legal as pects of Japanese society that made it inhospitable to foreign direct investment and to the importation and consumption of foreign goods 16 Fortunately since the mid1990s this situation has been changing The unusual independence and power of the government bureau cracy accompanied by bureaucratic fragmentation within the govern ment provide yet another distinctive aspect of the Japanese state that sets it apart The economic and other bureaucracies of the govern ment are virtually independent fiefdoms With few major exceptions each bureaucracy represents a particular segment of Japanese society and believes that it has a responsibility to promote the interests of that group There are frequent disputes among agencies over policy and jurisdictional responsibility these have increased as new technol ogies and economic developments have spread across the traditional functions of government agencies Chalmers Johnson has made the 15 The central role of the Japanese state in the formation of the Japanese economy and economic psychology has been demonstrated by Sheldon Garon Molding Japanese Minds The State in Everyday Life Princeton Princeton University Press 1997 16 Edward J Lincoln Japans Unequal Trade Washington DC Brookings Institu tion 1990 159 C H A P T E R S E V E N point that the three major economic agencies responsible for foreign affairs frequently have differing foreign economic policies that con flict with those of the other agencies Although bureaucratic struggles exist in every country Japan does not have a powerful executive and therefore has no easy way to resolve such conflicts In addition the strong belief of the Japanese in consensus decisionmaking permits and even encourages stalemate and indecision Indeed during much of the postwar period the weak executive branch was of little conse quence because of the agreement within the Japanese political elite on the path that all should follow By the late 1990s however it became clear that the weakness of the Japanese executive had become a serious obstacle to Japans ability to deal with its difficult economic and financial problems Another distinctive feature of Japanese society is that many pub lic responsibilities have been assumed by the private sector For ex ample private corporations carry a major responsibility for the social welfare of a substantial portion of the Japanese population Whereas the American government delegates regulatory authority to quasiau tonomous public agencies Japan delegates much of the responsibility for policing business activities to private business associations This has been a highly pragmatic practice based on the close ties and mu tual trust between private business and government There is a partic ularly interesting example of this practice in the delegation of public functions in the privatizing of law and order One reason for the low level of street crime in Japan is that the yakuza the Japanese Mafia police the streets in exchange for police toleration of their businesses This practice of selfregulation and selfpolicing by business and other private associations is intended to provide social stability and ensure fairness However it does result in special treatment of partic ular groups seemingly arbitrary decisions and discriminatory behav ior this practice of selfregulation is also directly counter to the American concept of universal rules that apply equally to everyone regardless of status Cultural differences in the definition of fairness have been a major source of AmericanJapanese economic tension that has on occasion erupted into open conflict The Japanese prac tice of private associations assuming essentially public responsibilities has raised significant problems in the integration of Japan into the world economy For cultural and other reasons the Japanese find it virtually impossible to incorporate outsiders into the selfregulating associations that set the rules governing competitive behavior and other aspects of the conduct of business in Japan while foreign com 160 S Y S T E M S O F P O L I T I C A L E C O N O M Y panies seeking entry into the Japanese market naturally regard the practice of selfregulation as discriminatory The selfpolicing system with its emphasis on fairness and on tailormade rules enforced in selfregulatory associations may conflict with the rules embodied in the World Trade Organization WTO and is thus an immense hurdle to be cleared to open the Japanese market and internationalize Japan more completely Industrial policy has been the most controversial aspect of the Japa nese political economy 17 As I have already noted industrial policy refers to deliberate efforts of a government to guide and shape the overall structure of the economy In the early postwar decades the Japanese provided government support for favored industries espe cially for hightech industries through trade protection generous subsidies and other means The government also supported creation of cartels to help declining industries and to eliminate excessive com petition 18 Through subsidies provision of lowcost financing and especially administrative guidance by bureaucrats the Japanese state plays a major role in the economy 19 The effectiveness of Japanese industrial policy has been very con troversial and a matter of intense debate On one side are revisionist scholars and proponents of the developmental state who attribute Ja pans success to its unique economic system and the governments powerful role in the economy The opposing position is held by American and some Japanese economists who emphasize Japans marketconforming economic strategy Chalmers Johnsons MITI and the Japanese Miracle The Growth of Industrial Policy 19251975 1982 in which he credits Japans Ministry of Trade and Investment MITI with having orchestrated postwar economic and technological success is the most outstanding statement of the revisionist or developmental state position 20 Accord 17 A useful and sympathetic treatment of Japanese industrial policy is Miyohei Shino hara Industrial Growth Trade and Dynamic Patterns in the Japanese Economy Tokyo University of Tokyo Press 1982 A wideranging discussion of Japanese in dustrial policy from several different perspectives is Hugh Patrick ed with the assis tance of Larry Meissner Japans HighTechnology Industries Lessons and Limitations of Industrial Policy Seattle University of Washington Press 1986 18 Jeffrey R Bernstein Japanese Capitalism in Thomas K McCraw ed Creating Modern Capitalism How Entrepreneurs Companies and Countries Triumphed in Three Industrial Revolutions Cambridge Harvard University Press 1997 19 For a discussion of administrative guidance consult Bernstein Japanese Capital ism 479 20 Chalmers Johnson MITI and the Japanese Miracle The Growth of Industrial Pol icy 19251975 Stanford Stanford University Press 1982 161 C H A P T E R S E V E N ing to Johnson Japan is a capitalist developmental state rather than an Americanstyle capitalist regulatory state He credits MITI and other Japanese bureaucracies for Japans outstanding postwar eco nomic success MITI and other agencies employed such techniques as import protection government subsidies and lowcost financing to promote rapid industrialization and development of the hightech sec tors In the opinion of Johnson and other revisionists the most im portant instrument of Japans successful industrial policy was the de vice of administrative guidance which was utilized to encourage and sometimes pressure private firms to invest in those industrial and hightech sectors characterized by high valueadded and favored by the government In addition Japans export success has been due to its neomercantilist strategy of exportled economic growth On the other side of the debate many American and some Japanese economists argue that Japanese economic success has been due to the fact that Japan pursued marketconforming economic policies and thus got the economic fundamentals correct 21 They call attention to Japans high savings and investment rate superior management and entrepreneurship and excellent system of education as bearing the primary responsibilities for Japans success In addition the Ministry of Finance MOF has pursued stable and prudent macroeconomic policies Explaining Japans export success many note that Japan as a resourcepoor and capitalskilled laborrich economy has had a comparative advantage in manufacturing and industrial innovation 22 According to this position Japans industrial policy had very little to do with its economic success and has even wasted resources 23 Nota ble examples of failure are found in MITIs efforts to promote fifth generation computers and a petrochemical industry A more infamous example is provided by MITIs effort to prevent Honda from becom ing an automobile producer because MITI believed that Japan could not support another automobile company There is considerable evidence on both sides of this debate but the outcome remains inconclusive because there is no counterfactual 21 Hugh Patrick Asias New Giant How Japans Economy Works Washington DC Brookings Institution 1976 and Edward F Denison and William K Chung How Japans Economy Grew So Fast The Sources of Postwar Expansion Washing ton DC Brookings Institution 1976 22 Gene M Grossman Explaining Japans Innovation and Trade A Model of Qual ity Competition and Dynamic Comparative Advantage Bank of Japan Monetary and Economic Studies 8 no 2 September 1990 75100 23 A valuable assessment is provided by Daniel I Okimoto Between MITI and the Market Japanese Industrial Policy for High Technology Stanford Stanford University Press 1989 162 S Y S T E M S O F P O L I T I C A L E C O N O M Y experience to indicate whether Japan would have been more or less successful without government intervention 24 Certainly as critics charge MITI made many mistakes and wasted resources Yet several comments can be made in support of Japans industrial policy The governments support and protection of private firms in favored in dustrial sectors has been central to Japans industrial policy MITI and other Japanese economic bureaucracies supportive policies were very important in enabling Japanese firms to close the technological gap with American and other Western hightech industries For exam ple Japanese competition antitrust policy encouraged the formation of the keiretsu and by almost all accounts the keiretsu have been very important to Japans industrial efficiency and international competi tiveness In the early postwar years the Japanese government selected a small number of powerful firms to be protected from both domestic and especially foreign competition these protected firms were given tax credits and subsidies that enabled them to develop rapidly 25 The government also supported technological developments through pro motion of cooperative research programs and other means Once the technology was fully developed the government strongly encouraged domestic but not foreign competition to increase the firms effi ciency This government support encouraged corporate strategies that emphasized profitmaking at home and increased market share abroad It is a mistake to assume as some neoclassical economists do that one can make a clear distinction between government policy and private initiatives in Japan The extensive use of infant industry protection has provided an other key factor in the success produced by Japans industrial policy 26 Although it is undoubtedly correct as American economists argue that Japan and other governments have been largely unsuccessful in picking winnersthat is in selecting viable new industriesJapan has been very successful in protecting and supporting those sectors whose economic significance has been proved already in the United 24 This point is made by Ryutaro Komiya Planning in Japan in Morris Bornstein ed Economic Planning East and West Cambridge Mass Ballinger 1975 More over as Komiya one of Japans most distinguished postwar international economists points out elsewhere Japans industrial policy and its goals have changed considerably over the course of the postwar era Komiya Industrial Policy in Japan Japanese Economics Studies summer 1986 5380 25 Ryuzo Sato Rama Ramachandran and Shunichi Tsutsui Protectionism and Growth of Japanese Competitiveness in Dominick Salvatore ed Protectionism and World Welfare New York Cambridge University Press 1993 Chapter 13 26 Ito The Japanese Economy 163 C H A P T E R S E V E N States and elsewhere automobiles consumer electronics and scien tific instruments 27 Among the policies Japan has used to promote these infant industries have been the following 1 Taxation financial and other policies that encouraged extraordi narily high savings and investment rates 2 Fiscal and other policies that kept consumer prices high corpo rate earnings up and discouraged consumption especially of for eign goods 3 Strategic trade policies and import restrictions that protected in fant Japanese industries against both imported goods and estab lishment of subsidiaries of foreign firms 4 Government support for basic industries such as steel and for generic technology like materials research 5 Competition antitrust and other policies favorable to the keire tsu and to interfirm cooperation Japanese industrial policy was most successful in the early postwar years when Japan was rebuilding its wartorn economy However as Japan closed the technology gap with the West and its firms became more powerful in their own right Japans industrial policy became considerably less significant in the development of the economy Yet the population and the government continued to believe that the state should play a central or at least an important supportive role in the continuing industrial evolution of the economy Corporate Governance and Private Business Practices The Japanese corporate system of industrial organization differs in several important respects from that of other industrialized econo mies 28 Although its distinctive features have been undergoing impor tant changes due to the maturing of the Japanese economy and to the economic stagnation in the late 1990s fundamental differences re main between the Japanese and Western economic systems 29 Three 27 An excellent example of Japanese industrial policy has been the governments pro motion of the Japanese automobile industries During my several stays in Japan I was impressed by the flawless condition of Japanese cars A major reason I was informed by Frank Upham a New York University expert on Japanese law was a set of govern ment policies with respect to auto insurance and inspections that created strong incen tives for Japanese consumers to purchase new cars Then the consumers replaced cars were shipped abroad to Southeast Asia and in the 1990s to Russia 28 Ryutaro Komiya The Japanese Economy Trade Industry and Government Tokyo University of Tokyo Press 1990 Part II 29 Paul R Krugman Trade with Japan Has the Door Opened Wider Chicago University of Chicago Press 1991 164 S Y S T E M S O F P O L I T I C A L E C O N O M Y of the most important differences are in the systems of industrial rela tions of corporate finance and of industrial organization Although these elements are closely tied to one another and reinforce one an other it is useful to consider them independently The Japanese system of industrial relations has been characterized by a dual labor market The core workers in Japans large and highly competitive corporations such as Sony and Toyota have enjoyed life time employment have been paid on the basis of seniority and have been considered stakeholders to whom Japanese firms have a social responsibility Although the system has been strongly criticized and is being eroded by Japans economic problems one advantage of this system has been that because lifetime workers are considered long term assets Japanese firms have a strong incentive to invest in labor ers skills However a major disadvantage of lifetime employment has been that it restricts the flexibility of Japanese firms and makes it difficult to reward younger and more valuable workers it has also been nearly impossible to fire incompetent or redundant workers On the other hand the majority of workers especially women and work ers in smaller firms have little job security and do not receive an equivalent share of the benefits of the system Whereas American firms tend to obtain the largest portion of their capital from the huge American stock market Japanese firms rely on retained earnings and most importantly on an affiliated bank Bank loans have generally been guaranteed by the government either di rectly or at least implicitly The Japanese banking system including the governmentrun postal savings system tight capital controls and government macroeconomic policies have enabled Japanese firms to enjoy very low capital costs As Kent Calder has shown this financial system has been a crucial component in what he calls Japans strate gic capitalism 30 Whereas American firms emphasize safeguarding both profitability and the interests of shareholders Japanese firms have considered their primary responsibility to be toward a firms stakeholders and stake holders include employees and subcontractors American firms seek to maximize profits Japanese firms have attempted to maximize sales and corporate growth Differences like these led Alan Blinder former member of the Federal Reserve to question whether or not the Japa nese economy was really capitalist 31 30 Kent E Calder Strategic Capitalism Private Business and Public Purpose in Japa nese Finance Princeton Princeton University Press 1993 31 Alan S Blinder More Like Them American Prospect 8 winter 1992 53 165 C H A P T E R S E V E N The keiretsu a business grouping or conglomerate whose members are bound together by the mutual trust and longterm relationships among a number of major firms their suppliers and their distribution networks is a particularly important component of the Japanese cor porate system 32 At the heart of every keiretsu is a major bank re ferred to in Japan as the main bank system that supplies credit and plays a key role in the keiretsus economic strategy Informal ties among member firms are reinforced by overlapping memberships on governing boards mutual stock ownership and other mechanisms The purpose of these structures is to serve the interests of stakehold ers rather than shareholders There are horizontal keiretsu enterprise groups such as Mitsui Mitsubishi and Sumitomo that are composed of a few dozen members and include a large bank manufacturing firms and a distribution network along with other elements 33 In ad dition there are vertical keiretsu composed of a parent manufacturing company and a large network of longstanding subcontractors and suppliers of services The approximately two dozen vertical keiretsu include leading Japanese manufacturing corporations in the automo tive and consumer electronics industries such as Toyota and Matsu shita Together the vertical and horizontal keiretsu control much of Japanese business Dominant firms in a keiretsu may exploit andor promote the strengths of their junior partners For example the parent firms work with their extensive stable of longterm and trusted subcontractors to increase the latters technological capabilities and to improve the quality of the components supplied to the parent The parent even shares exclusive information with its affiliates and this greatly en hances the overall efficiency of the keiretsu The extensive presence of the keiretsu in the Japanese economy thus has profound conse quences for the nature of Japanese domestic and international eco nomic competition and for the dynamics of the Japanese economy Market share rather than profit maximization has been the principal driving force in Japanese corporate strategy a large market share in creases economies of scale and benefits the firms stakeholders Even 32 Kester Japanese Takeovers 33 The six or so horizontal keiretsu are the direct descendants of the prewar zaibatsu that the Occupation sought to destroy and thought they had The principal characteris tics of these groupings is that the members in each grouping hold one anothers shares and have interlocking directorates The presidents of member firms meet frequently to formulate strategy and decide upon joint policies The members of the group also coop erate in financial matters R D activities and marketing Together these six indus trial groupings have a powerful presence in the Japanese economy 166 S Y S T E M S O F P O L I T I C A L E C O N O M Y though the Japanese economy is highly regulated compartmentalized and overprotected this market is in fact extraordinarily competitive For example Japan has a number of automobile companies whereas the United States has only three Competition in Japan does tend to be oligopolistic and Schumpeterian that is it is based on technologi cal innovation and is qualitydriven rather than based on price com petition consumer prices are kept high by government policies to in crease the profits of the corporate sector In his book on the governance of Japanese corporations Carl Kes ter makes a convincing argument that the keiretsu is a highly efficient and rational mechanism for organizing economic activities and its distinctive characteristics make it a formidable competitor in world markets 34 Mutual trust for example substantially reduces transac tion costs Information exchange within the keiretsu decreases uncer tainties and is conducive to innovative activities Intragroup cross shareholding protects members against hostile takeovers and signifi cantly reduces the cost of capital 35 The system is a mutual assistance society and when a member firm gets into trouble other members come to its rescue Corporate leaderships independence from outside shareholders permits the firm unlike American management to pursue a corporate strategy based on maximizing market share rather than shortterm profit maximization As Ronald Dore has argued the keiretsu con tributes greatly to Japans remarkable capacity to adjust to economic technological and other changes 36 Certainly no other country was as successful as Japan in adjusting to the two oil price rises of 1973 1974 and 19791980 Despite the troubles of the Japanese economy in the 1990s the keiretsu has proved to be a successful innovator of new products and production techniques because of its immense in ternal resources and longterm perspective The keiretsu mechanism has effectively joined the financial and other advantages of the large firm with the flexibility and innovative capabilities of the small firm Although or perhaps because the keiretsu is a highly effective means of industrial organization it has been deeply resented by non Japanese One reason for this resentment is that the keiretsu is a closed system that excludes all outsiders The term outsider in cludes not only nonJapanese firms but any Japanese firm that is not 34 Kester Japanese Takeovers 35 Robert Zielinski and Nigel Holloway Unequal Equities Power and Risk in Ja pans Stock Market New York Kodansha International 1991 36 Ronald P Dore Flexible Rigidities Industrial Policy and Structural Adjustment in the Japanese Economy London Athlone 1986 167 C H A P T E R S E V E N a member of the alliance of stakeholders who share the monopolistic rents generated by this oligopolistic form of business organization The exclusive nature of the keiretsu system has significantly limited foreign firms access to the Japanese market The keiretsu also makes it extremely difficult for foreign firms to take over Japanese firms and gives Japanese firms a huge advantage in corporate expansion Whereas the keiretsu firms can easily purchase a nonJapanese firm in order to acquire its technology or to gain market access it has frequently been difficult for nonJapanese firms to purchase Japanese firms for the same purposes Furthermore the keiretsus control of distribution channels effectively shuts nonJapanese firms out of some Japanese markets Although the situation is changing as this is writ ten nonJapanese still regard the keiretsu as a significant barrier to trade and foreign direct investment while the Japanese on the other hand regard the keiretsu as a key element in their economic success The problem of differential or asymmetrical access has been a major cause of conflict between Japan and its trading partners The German System of Social Market Capitalism The German economy has some characteristics similar to the Ameri can and some to the Japanese systems of political economy but it is quite different from both in other ways 37 On the one hand Germany like Japan emphasizes exports and national savings and investment more than consumption 38 However Germany permits the market to function with considerable freedom indeed most states in Western Europe are significantly less interventionist than Japan Furthermore except for the mediumsized business sector Mittelstand the non governmental sector of the German economy is highly oligopolistic and is dominated by alliances between major corporations and large private banks The German system of political economy attempts to balance social concerns and market efficiency 39 The German state 37 This section draws from Philip Glouchevitch Juggernaut The German Way of Business Why It Is Transforming Europeand the World New York Simon and Schuster 1992 38 Gunter Heiduk and Kozo Yamamura eds Technological Competition and Inter dependence The Search for Policy in the United States West Germany and Japan Seattle University of Washington Press and Tokyo University of Tokyo Press 1990 39 The German system is representative of classical liberalism that emphasizes a free market and a strong welfareoriented state See Razeen Sally Classical Liberalism and International Economic Order Studies in Theory and Intellectual History New York Routledge 1998 168 S Y S T E M S O F P O L I T I C A L E C O N O M Y and the private sector provide a highly developed system of social welfare The German national system of political economy is representative of the corporatist or welfare state capitalism of continental Eu rope in which capital organized labor and government cooperate in management of the economy This corporatist version of capitalism is characterized by greater representation of labor and the larger soci ety in the governance of corporate affairs than in AngloSaxon share holder capitalism 40 Although the continental economies differ from one another in many respects in all of them the state plays a strategic role in the economy It is significant especially in Germany that ma jor banks are vital to the provision of capital to industry While in many European countries employee councils have some responsibil ity for running the company in Germany labor has a particularly important role in corporate governance Indeed the law of codeter mination mandates equal representation of employees and manage ment on supervisory boards Although the power of labor on these boards can be easily overstated the system is a significant factor in Germanys postwar history of relatively smooth labor relations Ever since Chancellor Otto von Bismarck took the first important steps toward the modern welfare state in the late nineteenth century the German state has assumed a major role in providing public wel fare for every citizen This national commitment to advance the over all welfare of the German people has rested on the extraordinary ef ficiency of German industry In the modern era pairing industrial efficiency with public welfare has been made manifest in the concept of the social market Germany emphasizes the values of domestic harmony and community Worker benefits include a greatly reduced workweek unemployment insurance health care and lengthy vaca tions By one reckoning the cost of benefits is equal to about 80 percent of a workers takehome pay The nations high rate of pro ductivity growth has enabled the German nation to provide these gen erous social welfare benefits but these especially generous welfare programs have imposed a large burden on German business Economic Role of the State The most important contribution of the German state to the eco nomic success of their economy has been indirect During the postwar era the German federal government and the governments of the indi vidual Lander states have created a stable and favorable environ 40 Katzenstein Corporatism and Change 169 C H A P T E R S E V E N ment for private enterprise Their laws and regulations have success fully encouraged a high savings rate rapid capital accumulation and economic growth Germany has a highly developed system of codified law that reduces uncertainty and creates a stable business climate the American common law tradition guides US business and the Japa nese bureaucracy relies on administrative guidance At the core of the German system of political economy is their central bank or Bundesbank The Bundesbanks crucial role in the postwar German economy has been compared to that of the German General Staff in an earlier German domination of the Continent Movement toward the European Economic and Monetary Union has further increased the powerful impact of the Bundesbank Although the Bundesbank lacks the formal independence of the American Fed eral Reserve its actual independence and pervasive influence over the German economy have rested on the belief of the German public that the Bundesbank is the defender of the mark euro and the staunch opponent of dreaded inflation Indeed the Bundesbank did create the stable macroeconomic environment and low interest rates that have provided vital support to the postwar competitive success of German industry The role of the German state in the microeconomic aspects of the economy has been modest The Germans for example have not had an activist industrial policy although like other advanced industrial countries the government has spent heavily on research and develop ment The German government however has not intervened signifi cantly in the economy to shape its structure except in the support it has given through subsidies and protection to such dying industries as coal and shipbuilding and the stateowned businesses such as Luf thansa and the Bundespost mail and telecommunications However since the early 1990s these sectors have increasingly been privatized On the whole the German economy is closer to the American mar ketoriented system than to the Japanese system of collective capi talism Corporate Governance and Private Business Practices The German system of corporate governance and industrial structure has noteworthy parallels to the Japanese system As in Japan power ful national organizations such as the Bundesverband der Deutschen Industrie and the Deutscher Industrieund Handelstag represent the interests of business in national affairs and labor is also well orga nized at the national level IG Metall an organization that represents the auto and metal workers as well as other industries can speak for 170 S Y S T E M S O F P O L I T I C A L E C O N O M Y German labor in a way that the American Federation of LaborCon gress of Industrial Organizations cannot for American workers Japa nese organized labor on the other hand is fragmented into company unions and has almost no influence on either company or national affairs The system of codetermination at the level of the firm has made German labor a partner albeit a junior partner in corporate governance German industrial organization has certain noteworthy features One element is the prominent role played in the economy by medium sized privately owned firms called the Mittelstand Despite the inter national prominence given to Germanys large corporations such as Siemens or DaimlerBenz the Mittelstand constitute an important reason for German economic success They are major exporters and are especially strong as suppliers of such intermediate goods as chemi cals and machine tools The second major component in German suc cess is the publicly owned corporations whose shares are traded freely on the German stock market Nevertheless corporations such as these are much less important in the German economy than in the American economy In fact in the 1990s there were only about six hundred fifty German companies listed on the stock market and only about one hundred twenty were actively traded The firms that are most important in the overall structure and governance of the Ger man economy are the banklinked corporations The integration of finance and industry has been a noteworthy fea ture of corporate governance in Germany Although more informal than the Japanese keiretsu longterm bankcorporate ties are a cru cial element in the system The major universal banks ie those that perform all financial services such as the Deutsche Bank and the Commerzbank are worthy of particular attention Representatives of these banks and of the large German multinational corporations sit on one anothers boards of supervisors In important ways the system of crossownership and interlocking boards resembles the Japanese keiretsu with their integration of financial industrial and distribution activities the system facilitates the sharing of vital information pro vision of less expensive investment capital and coordination of economic planning Also like the keiretsu the system emphasizes longterm relationships based on negotiated prices and supply ar rangements among corporations However German participants in these arrangements seek to advance the interests of their particular firm rather than those of the whole organizational alliance It is im portant to note that as the German economy has globalized the link ages between banks and industry have weakened 171 C H A P T E R S E V E N Bankingindustry ties have reduced conflict between industrial and financial interests over economic policy Because of their pervasive financial power and their linkage with key industries the major Ger man banks play a central role in the governance of industry and in overall strategic planning for the German economy While the Ger man corporate world like the Japanese is closed the German econ omy itself is open and the German legal system and codified adminis trative procedures ensure that foreign businesses will be treated in a legally fair manner The powerful influence of German universal banks over the econ omy is primarily a function of the considerable freedom the banks enjoy to enter a great variety of business activities Under the system of universal banking German banks can participate in almost every conceivable financial activity from commercial to investment to mer chant banking Until the 1990s American commercial and investment banking on the other hand was restricted by the GlassSteagal Act of the early 1930s In this system different activities have been con ducted by different types of institutions while German universal banks have had a hand in almost every facet of German financial and business affairs For example industrial financing is supplied princi pally through bank loans rather than through issuance of stock or commercial paper The banks also own large portions of German companies and the supervisory boards of German industry are fre quently dominated by bankers Industrial firms prize their ties with the banks because in addition to ensuring lower cost capital this arrangement has provided security against hostile takeovers and inter fering shareholders The strategic role of banks and the close links between banks and industry in the German economy are largely the result of Germanys experience as a late industrializer As Alexander Gerschenkron and Thorstein Veblen before him pointed out the timing of industrializa tion is a key factor in determining the mechanism of capital accumu lation and the overall structure of a nations industrial system 41 In contrast to Great Britain and the United States where capital was initially accumulated largely in the hands of individual entrepreneurs in Germany and other continental European countries there was rela tively little capital in the hands of individuals In these circumstances the banks became the principal means of amassing sufficiently huge 41 Alexander Gerschenkron Economic Backwardness in Historical Perspective A Book of Essays Cambridge Belknap Press of Harvard University Press 1962 and Thorstein Veblen Imperial Germany and the Industrial Revolution New York Mac millan 1915 172 S Y S T E M S O F P O L I T I C A L E C O N O M Y amounts of investment capital to expedite industrialization and catch up with the industrial leaders This historic linkage between finance and industry has continued in both Germany and Japan The most influential of the major German universal banks is with out question the Deutsche Bank DB The DBs pivotal position in the German economy may be gauged by its holdings in the nations major corporations it has a substantial stake in DaimlerBenz Ger manys largest corporation and it also has substantial holdings in Germanys leading insurance company Allianz its largest reinsur ance company Munich Re and its major department store chain Karstadt The list of bluechip companies in which DB has a large stake could easily be lengthened In addition members of the upper management of DB are on the supervisory boards of over one hun dred fifty German corporations German government policies have supported and reinforced the po sition of Germanys major private banks in corporate governance Corporate law has empowered banks by giving considerable rights to minority shareholders For example corporate law has required that 75 percent of the shareholders in a public corporation must approve any change in the corporations capitalization and hence in the gov erning structure of a firm This means that a bank with only a 26 percent share can block change Since in certain circumstances the banks can also vote the shares of their account holders this provides banks with considerable influence over corporate affairs The governing structure of German industry is affected by the German governments tolerance of the concentration of economic power by horizontal cooperation and by the linkages between fi nance and industry Despite the fact that the American Occupation after World War II attempted to wipe out the German cartel tradition and to promote an antitrust mentality this mentality remains rela tively weak in Germany The decision of the German government to permit DaimlerBenz to acquire MesserschmittBolkowBlohm Ger manys largest defense and aerospace firm is an example of German tolerance of the concentration of economic power Subsequent ly DaimlerBenz eliminated its interests in MesserschmittBolkow Blohm German management is less restricted by shareholder concerns about annual returns on their investments than is American manage ment Freedom from outside scrutiny has unfortunately sometimes protected the incompetent but it has enabled German management to pursue longterm plans This situation began to change in the late 1990s but previously management independence had been greatly 173 C H A P T E R S E V E N enhanced by the system of dual boards In Germany there is both a supervisory board comparable to the American board of directors and a management board composed of the chief executive and top management While in theory the supervisory board is the superior body in actual practice the management board which is fulltime and functions on the basis of consensus is frequently dominant This empowerment of management strengthens managements ability to make longterm strategic decisions The structure and governance of German industry is also signifi cantly influenced by the negative German attitude toward corporate takeovers The methods used to prevent hostile takeovers are legion for instance companies may simply stay private stock may be distrib uted to increase resistance blocking minorities may be employed German corporate law can be utilized to discourage takeovers and voting rights can be restricted Whereas in the United States corpo rate takeovers are defended as a blunt but effective means to guaran tee high performance and to demonstrate the ultimate responsibility of management to the shareholders in Germany takeovers have been regarded as destabilizing and destructive of important longterm busi ness relationships A number of American executives discovered this to their chagrin when they attempted to gain control of the Deutsche Bank This attitude has made corporate takeovers and struggles over corporate governance rare in Germany and German banks have sel dom sold their stakes in German corporations This situation how ever began to change in the late 1990s Significance of National Differences This chapter has analyzed and compared the three national systems of political economy dominant at the beginning of the twentyfirst century The American system incorporates neoclassical precepts re garding the organization and functioning of an economy intended to maximize consumer satisfaction and facilitate adjustment to change Many other countries consider the social costs of such an economy to be too high because of their impact on poverty and on those who lose through economic developments The Japanese system places a high priority on social harmony and national power but its critics consider that system to be inflexible mercantilistic and unresponsive to the concerns of other societies The German emphasis on the social market has many of the virtues and vices of both the American and Japanese systems Although each of these economies was experiencing important changes at the turn of the century they remained distinctly 174 S Y S T E M S O F P O L I T I C A L E C O N O M Y different from one another and their fundamental differences are sig nificant for the nature and dynamics of the world economy The significance of the differences among national economies be came more and more apparent in the late 1960s and 1970s as a con sequence of the increasing interdependence of national economies As economies became more integrated with one another the domestic and international spheres became more closely linked to one another and national policy makers became more and more concerned about the domestic economic structures and private economic practices of other societies that might affect the welfare of their own citizens and nations As these national differences have become more significant several questions have arisen 1 Is one national system superior to the others and should it therefore be the model for other economies 2 Do national systems of political economy compete with one an other in a Darwinian struggle for survival and dominance and 3 Are systems of political economy converging Is One System Superior to the Others At one time or another during the postwar era one or another na tional economy has been declared superior In the 1970s the German system of the Social Market was assigned credit for the postwar Ger man economic miracle as one enthusiastic writer stated West Ger many had become a juggernaut and a challenge to all other econo mies In the 1980s attention shifted to Japan which was then enjoying a huge trade surplus and a rapid rate of economic growth at that time the Japanese system of stateled capitalism or develop mental state capitalism became the envy of the rest of the world and the model to be emulated Both Germanys and Japans stakeholder capitalist systems were judged superior to Americas shareholder stockholder capitalism in part because the former were believed to free corporate leaders from shortterm shareholder demands for higher dividends and thus to enable them to take a longterm view in their investment and other decisions When Japan plunged into a seri ous financial crisis and recession in the 1990s the prize for best per formance went to the United States whose economy was booming throughout much of the decade American public officials econo mists and commentators announced that Americas shareholder and freemarket capitalism had proved superior to all others The out standing success of the American economy many argued was due to the fact that in the 1980s and 1990s the United States had created a novel type of economy based on a New Economic Paradigm The 175 C H A P T E R S E V E N rest of the world Americans proclaimed should adopt their model of deregulation open markets and minimal government intervention in the economy The claim that one economy is superior to others is difficult to assess Nations differ greatly in their standards of judgment Should one apply such criteria as the rate of economic growth the extent of economic equality and social wellbeing or perhaps what some have called a misery index National values obviously differ on these matters The French for example reject what they consider to be the ruthlessness of Americas emphasis on the market and its insufficient attention to the problems of income inequality and economic insecu rity Many American observers on the other hand believe that the overly protective nature of the French state is largely responsible for Frances economic troubles especially its very high rate of unemploy ment In short an economic system strongly reflects the values of the society in which it is embedded and must be judged at least to some extent in terms of those values The Japanese keiretsu for example would certainly be incompatible with American opposition to concen trations of economic power The most objective measures of national economic performance are an economys rates of economic and productivity growth However even these measures have limitations Productivity particularly in those service industries that increasingly characterize the American and Western European economies is difficult to measure Another difficulty is that when an economy is beyond a certain level of eco nomic development its performance at any particular moment is more a function of the phase of the business cycle than of the econo mys inherent features Although economists and governments do not yet know how to manage an economy to avoid the business cycle a governments use of macroeconomic policy obviously significantly influences national economic performance Despite the difficulties of the endeavor the effort to determine whether particular economic arrangements are superior to others has engaged many scholars Karl Marx Joseph Schumpeter and Alexan der Gerschenkron have been among these scholars One theme of these early writers as well as more recent commentators is that the stage or timing of economic development determines the nature and appropriateness of an economic system Each stage in the evolution of technology and other aspects of capital accumulation is said to require a different form of economic and sociotechnological organiza tion Gerschenkron for example argued that the method of capital accumulation by business enterprise banking system or state was 176 S Y S T E M S O F P O L I T I C A L E C O N O M Y determined by the timing of economic development Whereas Great Britain and the United States as early industrializers relied on capital accumulation by entrepreneurs and by shareholders Germany and Japan as late starters emphasized accumulation by powerful banks and the USSR and China as late late developing countries depended on stateled capital accumulation A similar theme has been set forth by business economist Alfred Chandler 1977 and other scholars 42 Each stage in the development of technology this position argues requires new and appropriate in stitutional arrangements In fact national institutional and societal restructuring is frequently necessary to take advantage of new tech nologies 43 For example it could be argued that the open and free wheeling American economy is appropriate for the age of the Internet Whether it is correct or not this argument suggests that flexible and adaptable economic and other institutions are desirable Another for mulation of the evolving institutional requirements for economic suc cess has been set forth by Robert Wade in his argument that whereas the Japanese and East Asian economic model of stateled industrial ization and capital accumulation is appropriate for economic takeoff the American system of maximizing returns through the optimum al location of the existing capital stock and national savings may be better suited to maintaining economic stability in an industrialized economy 44 Another approach to understanding superiority has been taken by Jeffrey Hart in his book Rival Capitalists International Competitive ness in the United States Japan and Western Europe 1992 He argues that variations in statesocietal arrangements determine the success and international competitiveness of national economies 45 And Peter Katzenstein has made a strong case for the superior perfor mance of corporatist small West European countries 46 Although these ideas provide useful insights into the relationship of national 42 Alfred D Chandler Jr The Visible Hand The Managerial Revolution in American Business Cambridge Belknap Press of Harvard University Press 1977 43 Carlotta Perez argues that an economys institutions must be tuned to the domi nant technologies of an era See Structural Change and Assimilation of New Technol ogies in the Economic and Social Systems FuturesThe Journal of Forecasting and Planning 15 no 5 October 1983 35775 44 Robert Wade The Asian DebtandDevelopment Crisis of 1997 Causes and Consequences World Development 26 no 8 August 1998 153553 45 Jeffrey A Hart Rival Capitalists International Competitiveness in the United States Japan and Western Europe Ithaca Cornell University Press 1992 46 Peter Katzenstein Small States in World Markets Industrial Policy in Europe Ith aca Cornell University Press 1985 177 C H A P T E R S E V E N systems and economic success economic performance is ultimately a function of many factors and cannot be completely explained by any particular institutional arrangement Moreover as the contributors to Suzanne Berger and Ronald Dores edited book National Diversity and Global Capitalism Domestic Institutions and the Pressures for National Convergence 1996 amply demonstrate different societies use different institutional arrangements to perform the same eco nomic functions 47 Although an economy may borrow best practice techniques and institutions from one another as happened when the United States and others adopted Japans system of lean production there is no onetoone correspondence across national economies be tween structure and function It is certain that some economic systems have failed miserably no tably the command economies of the former Soviet bloc and this suggests that there are some minimal requirements for economic suc cess Nathan Rosenberg and L E Birdzell demonstrate in How the West Got Rich 1986 that government policies and socioeconomic institutions must facilitate efficient flexible and innovative economic behavior 48 Whether through an unfettered market mechanism or some form of state interventionism a society must create incentives that encourage entrepreneurship innovation accumulation and effi cient use of the basic factors of production especially through invest ment in capital and skilled labor Society must also reward innova tive activities and support the economys ability to adjust to economic technological and other changes However such objec tives as these can be fulfilled by differing economic institutions and practices The outstanding performance of the American economy in the 1990s and the dismal failure of many other economies convinced most Americans as well as many others that the American economy should be the model for the rest of the world Throughout most of the decade the United States enjoyed a high rate of economic growth low unemployment and low inflation while Western Europe had a low rate of economic growth and a very high rate of unemployment After the collapse of its bubble economy in the early 1990s Japan entered a serious financial crisis and somewhat later a recession Al though the other Pacific Asian economies posted spectacular rates of 47 Suzanne Berger and Ronald Dore eds National Diversity and Global Capitalism Domestic Institutions and the Pressures for National Convergence Ithaca Cornell University Press 1996 48 Nathan Rosenberg and L E Birdzell Jr How the West Got Rich The Economic Transformation of the Industrial World New York Basic Books 1986 178 S Y S T E M S O F P O L I T I C A L E C O N O M Y economic growth throughout most of the 1990s they were hit by a severe financial crisis and recession in the fall of 1997 The economic pace slackened in China and the Russian economy was a disaster Thus for a period in the late 1990s the United States was an eco nomic oasis in a global economic desert American officials business leaders and popular commentators at tributed the prolonged success of the American economy to funda mental changes that had occurred in the 1980s and the 1990s Propo nents of the New American Economy argued that the American economy had been transformed by several factors deregulation in creased openness to the global economy downsizing and restructur ing of American corporations in the 1980s and rapid technological advances especially in the computer and information technologies that increased national productivity The globalization or openness of the American economy to imports kept prices down decreased inflationary pressures and hence permitted the Federal Reserve to pursue expansionary economic policies Deregulation of the Ameri can economy made it better suited than its Japanese and European competitors to take advantage of the digital revolution Some alleged that the productivity and international competitiveness of the Ameri can economy have significantly increased and surpassed the rest of the world Many even proclaimed that the American economy had transcended the boomandbust business cycles of the past There is no dispute about the overall success of the American econ omy in the 1990s Excellent management of the economy by the Fed eral Reserve as well as an upswing in the business cycle certainly played an important part in this success However it has not yet been demonstrated that the United States has created a superior economic model indeed good luck has played a role in American success For example the victory over inflation and consequent low interest rates can be attributed in large part to the fact that the rest of the world economy was in recession in the 1990s Moreover the American economy benefited greatly from a huge inflow of foreign capital that buoyed the stock market indeed by the late 1990s Americas na tional foreign debt had reached approximately 1 trillion Economic expansion was also funded by the virtual elimination of personal sav ings and a huge buildup of consumer and corporate debt Rapid eco nomic expansion was accompanied by increasing income inequalities job insecurity and serious social problems Despite the impressive achievements of the American economy in the 1990s one must re member that it is dangerous to argue that the American or any other economic model is and will be for all time superior to others 179 C H A P T E R S E V E N Do Nations Compete with One Another 49 The Clinton Administration assumed power believing that pursuit of a competitiveness strategy would restore the international competi tiveness of the American economy The United States as the President told the American people is like a big corporation competing in the global marketplace Clinton raised the competitiveness issue in response to Americas huge trade deficit and to growing concern about the deindustrialization of the economy The immense trade deficit with Japan alarmed the Administration and convinced many that the United States had become noncompetitive with Japan espe cially in hightech industries The newly elected President created the National Economic Council in response to these concerns and charged it to develop a national strategy to deal with such problems About the same time many West European leaders also began to express concern about the international competitiveness of Western Europe In June 1993 Jacques Delors then president of the European Commission stated that the European economys most basic problem was loss of international competitiveness The fundamental reason for high unemployment he proclaimed was that Europeans were no longer competitive with the Americans and the Japanese and the so lution should be to increase competitiveness in hightech industries Other West Europeans have also spoken of the intense global eco nomic struggle Many political leaders and the general public began to believe that the economic wellbeing and even the political survival of Western Europe was at stake in this international struggle Al though both European and American concerns moderated in the late 1990s concern over competitiveness continued to be very much alive The idea that nations qua nations are engaged in a zerosum com petition for market share and economic superiority is anathema to every mainstream economist It was economist Paul Krugman who in an article in the Foreign Affairs journal 1994 launched the attack on the Clinton Administrations competitiveness strategy and even on the very idea of national competitiveness 50 Krugman previously had been a principal author of the theory of strategic trade and thus had inadvertently contributed to the intellectual rationale supporting the Administrations policies In a series of books and articles Krugman 49 The question of whether national differences lead to economic and political con flicts is discussed in my book The Challenge of Global Capitalism The World Econ omy in the 21st Century Princeton Princeton University Press 2000 Chapter 8 50 Paul R Krugman Competitiveness A Dangerous Obsession Foreign Affairs 73 no 2 MarchApril 1994 2844 180 S Y S T E M S O F P O L I T I C A L E C O N O M Y subsequently moderated his former enthusiasm for strategic trade and argued that international economic competition takes place between individual business firms and not between national economies Krug man and other American economists have noted moreover that since imports comprise just a small fraction of the American economy the principal competitors for most American firms are other American firms And interfirm competition is beneficial because it rewards effi cient producers benefits the consumer and leads to maximization of world wealth Whereas some individuals and governments believe that nations are engaged in a winorlose economic struggle economists argue that free trade and international competition benefit everyone indeed ac cording to the theory of comparative advantage every nation has a comparative advantage in something and can therefore be a winner The mercantilist or geoeconomics position of the Clinton Administra tion that emerged from belief in the winorlose struggle Krugman correctly warned would produce illconceived and reckless policies including wasteful industrial policies and confrontational trade poli cies Moreover he warned that emphasis on competitiveness diverted attention from such fundamental problems as Americas low savings rate and the declining skill level of an alarmingly large portion of the American workforce Indeed in the 1990s the United States found it necessary to import large numbers of engineers and scientists to staff its growing information economy As Krugman has pointed out the most appropriate measure of an economys performance is its productivity and not its balance of trade or of international payments 51 The national level of productivity and the rate of productivity growth not only constitute the true measure of an economys performance but also determine a nations longterm wellbeing For this reason Krugman and other economists have no objection to the term international competitiveness provided that such thinking refers to national productivity and gives rise to im proved government policies to increase national savings and invest ment in capital goods and in skilled labor It should be pointed out however that economic policies designed to increase a nations rate of productivity growth do not necessarily have any effect on a nations balance of foreign trade and interna tional payments although many noneconomists believe that there is a direct causal relationship The trade balance and payments balance of an economy are determined principally by its savingsinvestment 51 Productivity is a measure of the ratio of national output to national input 181 C H A P T E R S E V E N ratio and by macroeconomic fiscal and monetary policies Further more the productivity growth of one economy does not necessarily harm other economies and may even raise the economic welfare of others For example increased productivity of one economy can im prove the economic welfare of its trading partners by making the formers exports less expensive As a case in point no one could deny that the high rate of productivity growth of the Japanese automotive and electronics industries has benefited American consumers enor mously and has forced American firms to increase their own produc tivity and competitiveness in price and quality Although nations may not compete with one another in a narrow economic sense nations can be said to compete in a broader sense that is in their ability to manage their economic affairs effectively At particular times certain national economies are obviously superior in their ability to fashion and implement policies that promote eco nomic and productivity growth Beneficial economic policies encour age savings investment and education and also facilitate rapid ad justment of the private sector to economic and technological change Swedish economist Gunnar Eliasson stated that competitiveness can be defined as a nations ability to renew itself In this sense competi tiveness is ultimately the ability of a society to transform itself contin uously in response to economic political and technological changes The state and its policies must play a central role in transformation and adjustment markets alone will not succeed The state must ad dress such issues as market failures and the provision of such public goods as R D Eliasson believes that competitiveness depends on the economys flexibility both to adjust relative prices and to modify industrial structures by scrapping obsolete economic activities and thus releasing labor and capital to facilitate the development of viable new businesses The capacity of an economy to transform itself is a crucial characteristic in the global struggle to determine which na tions will develop a comparative advantage in those industries and economic activities most important to economic welfare and national power 52 The concept of the competitive state emerges from ideas ex pressed by Eliasson and incorporates Krugmans argument that it is firms and not states that compete The competitive state concept also incorporates the fact that firms are increasingly mobile as they seek 52 Gunnar Eliasson The Knowledge Base of an Industrial Economy Stockholm In dustrial Institute for Economic and Social Research distributed by Almqvist and Wik sell International 1988 182 S Y S T E M S O F P O L I T I C A L E C O N O M Y the most attractive locations in the global economy 53 Moreover it recognizes that governments cannot pick winners and that the choice of technologies must be left up to the private sector According to this concept however governments should be active and should not leave matters to the market alone As Vincent Cable has pointed out a competing nation attempts to strengthen the position of its firms in the global economy and attract foreign investment through cre ation of a pool of highly educated flexible workers an efficient physi cal infrastructure sound economic policies and an attractive quality of life 54 Such a competition strategy has been employed effectively by Singapore and has been adopted by Britain Ireland and other coun tries Germany is also moving in this direction However another significant example of a successful competitive state is the United States In 1980 for example responding to fears of deindustrializa tion the Congress passed the BayhDole Act that for the first time permitted universities to patent the results of federally funded re search and to license those results to private firms 55 Subsequent legis lation has strengthened this corporateuniversity alliance as a key ele ment in Americas competitive strategy in the area of hightech industries Many observers however do fear this could prove harm ful to the universities over the long term Convergence Harmonization or Mutual Recognition There are several possible solutions to problems engendered by na tional differences that have created obstacles to the smooth function ing and full development of the global economy Differences could be eradicated or moderated either through the functioning of the market as neoclassical convergence theory suggests or through political ne gotiations to achieve harmonization of national practices The con vergence position requires patience as it posits that national systems will converge through the operation of markets in which over time economic forces will cause nations to modify their economic struc tures and business practices Harmonization on the other hand is based on international negotiations and reciprocity leading to elimi 53 The implications of this fact are developed by Robert Reich The Work of Nations Preparing Ourselves for 21st Century Capitalism New York Knopf 1991 54 Vincent Cable The Diminished NationState A Study in the Loss of Economic Power in What Future for the State Daedalus 124 no 2 spring 1995 4850 55 This development and its potential dangers is discussed by Eyal Press and Jennifer Washburn The Kept University Atlantic Monthly 285 no 3 March 2000 3954 183 C H A P T E R S E V E N nation of national differences the negotiations between Japan and the United States over the Structural Impediments Initiative SII in the late 1980s is a prime example Both methods of accommodation are slow and the latter can be very confrontational Still a third way to deal with national differences is by application of the principle of mutual recognition in which nations agree to honor one anothers economic and business practices Indeed mutual recognition has been central within the movement toward European and to a lesser extent North American regionalism Convergence According to neoclassical convergence theory economic interdepen dence will ultimately lead to a convergence in economic performance among national economies as rates of economic growth productivity levels and national incomes move toward one another Many writers even argue that economic globalization necessarily forces convergence of the structural features of an economy and of private economic practices and that therefore national differences will disappear These persons argue that intensification of global economic competi tion expansion of trade and foreign direct investment and interpene tration of national societies necessitate that societies adopt similar domestic institutions and economic practices As other countries close the economic and technological gap with the more developed econo mies the role of the market will become more central in each econ omy then the policy prescriptions of neoclassical economicseco nomic openness noninterventionism and the likewill increasingly guide the economic activities of that society Many American econo mists and public officials argue that the superior performance of the American economy in the 1990s and the weaknesses of the once envied Japanese and other Pacific Asian economies have made the American economy and the free market the model for the world Some observers even proclaim that the convergence process leads the world toward individualism and political democracy The neoclassical position assumes that national variations in eco nomic performance are a function either of a catchingup process or of a countrys failure to manage its economy according to the policy prescriptions of neoclassical economics In this view the outstanding economic success of Japan and the East Asian Newly Industrializing Countries NICs was caused by their having had the advantage of backwardness and their ability to apply the experience and technol ogy of the more advanced economies when they mobilized national resources to expedite economic growth Then as countries develop 184 S Y S T E M S O F P O L I T I C A L E C O N O M Y they will inevitably converge toward the neoclassical model of a mar ket economy As these countries draw close to the more industrialized countries their growth rates will slacken and they will eventually settle down as more normal countries with more typical normal growth rates Since the end of World War II there has indeed been convergence in economic performance among the more advanced economies Con vergence in productivity levels and other economic indicators has taken place between the United States and the other industrialized economies largely as a consequence of trade liberalization However the gap between rich and poor countries has actually widened except in the case of the East Asian and a few other industrializing econo mies Some explain that most poor countries have failed to catch up because convergence can work only when political social and eco nomic institutions are conducive to economic development and are supportive of inward flows of capital and technology these condi tions did exist in East Asia The East Asian experience indicates that convergence between developed and less developed countries is not automatic but as Robert Barro has pointed out requires an appro priate social and political infrastructure 56 Another possible reason why so many less developed countries have failed to catch up with the developed economies is supplied by the new growth theory In that theory an initial advantage of one country over another in human capital can and usually will result in a permanent difference in income level between the countries This happens particularly when the differences in human capital are very large Developed countries rich in human capital can sustain a much higher level of economic output than can less developed countries with a low level of human capital thus the former will be able to maintain a decisive lead indefinitely by generating more new savings and investment than the less developed economy can generate Thus even though poor countries may be gaining in wealth the gap be tween them and the rich will continue If convergence in economic performance has been weak and un even what about convergence in economic institutions and business practices With economic globalization is the world gravitating to ward the American free market model It is certain that the increasing integration of national economies has encouraged societies to adopt particular institutions and practices proven especially successful else 56 Robert J Barro Economic Growth and Convergence Occasional Papers No 46 San Francisco International Center for Economic Growth 1994 185 C H A P T E R S E V E N where the spread of the Japanese technique of lean production to the United States Great Britain and elsewhere exemplifies this phenome non But this does not necessarily lead to the conclusion that eco nomic globalization has been homogenizing domestic economies The only significant examination that I have found of whether or not insti tutional convergence has really occurred is in Berger and Dores ed ited volume National Diversity and Global Capitalism mentioned earlier In a number of case studies the contributors to this excellent volume all of whom are experts on one or another of the economies examined seek to determine whether or not convergence of institu tions and domestic practices has been occurring the volume reaches the following conclusions 1 Despite some convergence in macroeconomic performance very little convergence has taken place at the level of national institu tions National institutions tend to be sticky or in the language of economics inelastic Societal changes are usually very costly strongly resisted and exceedingly slow 2 Differing but equally effective systems of corporate and other in stitutions within national societies limit the need for convergence to achieve particular objectives 3 External pressures may require a response or outcome but the character of the response is largely determined by domestic fac tors and is not limited to a unique or single response 4 Convergence of national institutions has been subject to interna tional negotiations it can seldom be identified as an automatic consequence of globalization 5 The domestic effects of globalization are largely determined by states themselves Despite this impressive study evidence suggests that important changes in economic behavior and structure have been taking place in a number of countries and that these changes tend primarily to ward the American model of shareholder capitalism The two most notable examples of this development are Germany and Japan Yet one should not jump to the conclusion at least not yet that the Ger man and Japanese economies are shedding their distinctive features The German system of stakeholder capitalism came under severe pressure in the 1990s The unification of Germany in 1989 imposed a very high and continuing financial burden on the German economy Germany has been required to pump substantial funds into the back ward economy of the former East Germany In addition German in dustry has had to deal with high labor costs both wages and welfare 186 S Y S T E M S O F P O L I T I C A L E C O N O M Y benefits and with the costly effort to create a unified European cur rency The tension between the costs of the overly generous German welfare state and the need for greater economic efficiency has consti tuted a serious problem and has encouraged German firms to estab lish production facilities in Eastern Europe the United States and elsewhere Moreover Germany for many years has had to contend with a chronic high rate of unemployment over 10 percent Most importantly Germany has become increasingly aware that fundamen tal reforms are necessary if it is to meet the combined challenges of economic globalization European economic integration and the in creasing importance of the Internet and information economy The growing pressure to internationalize production and to significantly increase the capital available to German industry to further the devel opment of hightech industries has placed a severe strain on the Ger man Social Market economy One of the central tasks of reforming and restructuring the German economy to bring it into the information age entails elimination or at least significant weakening of the close bankindustry alliances these powerful alliances are held together by webs of crossholdings and interlocking directorates This system has a number of major neg ative consequences it has tied up large amounts of capital in tradi tional industries and discouraged individual entrepreneurship In or der to transform itself into a hightech information economy Germany requires large amounts of capital to invest in new industries such a need prompted the unprecedented decision of DaimlerBenz to list DaimlerChrysler on the New York Stock Exchange a move that required the company to break with tradition and to open its books to outsiders Similar remarkable changes are taking place in Germany itself in response to the growth of a shareholder mentality that is creating a more vigorous and innovative German economic system Several events in early 2000 signaled that a significant change in the bankindustry alliance was taking place The first development was the bid of the British firm Vodafone AirTouch to acquire the German firm Mannesmann AG The initial reaction of the German government was to denounce the threatened hostile takeover as anti German and contrary to German culture Germany has always had a strong preference that German firms merge with other national firms and has opposed hostile takeovers The intense opposition to hostile and crossboundary mergers has been due to a corporate cul ture that favors consensus and the interests of such stakeholders as labor In the past a German bank would have stepped in and used its own capital to save the threatened German firm When in this 187 C H A P T E R S E V E N case no rescue took place this provided evidence that a fundamental feature of German economic culture was changing Another and even more important example of the profound change taking place in the German economy early in the year 2000 was the proposed merger of Deutsche and Dresdner banks engineered by the powerful insurance conglomerate Allianz AG Although the merger effort eventually failed it did signal an important change in German economic culture Such an initiative would have dismantled a key component of the bankindustrial system and led to the loss of many thousands of jobs an event unheard of in Germany This develop ment in turn would have led to a major restructuring of a key segment of the German economy Efforts to restructure German industry have been greatly facilitated by a new tax law that allows corporations to sell off their holdings and investments without paying capital gains taxes The purpose of these selloffs is to enable German banks and corporations to eliminate burdensome holdings and pave the way for the same type of corporate mergers acquisitions and takeovers as in the United States and elsewhere As a result Germany will be able to accelerate development of a more entrepreneurial and hightech economy appropriate for the world of the Internet and information economy These developments will undoubtedly transform Germany and make it more of a competing state As German investors are de manding greater transparency in the management of German business and a much higher rate of return on their investments the shift from stakeholder to shareholder capitalism will accelerate Equity culture is spreading fast in Germany and the rest of Europe and the number of shareholders is rapidly increasing Yet it is highly unlikely that the German social market economy will be wholly abandoned in favor of the Americanstyle freemarket economy Although welfare pro grams will be trimmed in the interest of greater efficiency and flexi bility the welfare state is too ingrained in German mentality to be abandoned In addition the practice of codetermination has given German labor a powerful voice in German firms and German unions have become so important in the overall economy that a Thatcher Reagan type of conservative ideology is unlikely ever to sweep that country In Japan the issue of institutional change has also become urgent Throughout the 1990s the Japanese system of political economy suf fered one serious setback after another In the early 1990s major problems arose with the collapse of the inflated bubble economy and resulted in a severe banking crisis Japans banks found them 188 S Y S T E M S O F P O L I T I C A L E C O N O M Y selves with a huge burden of underperforming or bad loans Subse quently in the late 1990s the East Asian economic crisis greatly ag gravated Japans economic slowdown and financial problems In 1998 Japan lunged into its deepest recession since the end of World War II moreover in contrast to past crises Japans exportled growth strategy has been unable to reinvigorate the economy and as these lines are written in the early spring of 2000 recession continues At a more fundamental level Japans rapidly aging population the overcapacity and low profitability of many export industries and the overall low level of productivity outside the export sector portend severe economic troubles in the decades ahead These accumulating difficulties have caused many Japanese to ac cept the idea that a radical deregulation and restructuring of the Japa nese political economy has become necessary For example Japans Economic Planning Agency EPA published a report in 1995 To ward the Revival of a Dynamic Economy in which it warned that Japan must either reform its economy or face longterm economic decline Essential to any significant reform would be a shift from an exportled to a domesticled growth strategy opening of the economy to greatly increased amounts of manufactured imports and to foreign direct investment and extensive deregulation of the economy Such steps some argue would lead to a significant revival of the economy increase overall productivity growth and enable Japan to become more of a leader in the world economy However powerful resistance from the Japanese bureaucracy and from entrenched private interests and the seeming indifference of the Japanese people lead to doubt about the ability or willingness of Japanese political leaders to make truly significant reforms in the economy Nevertheless Japans national system of political economy has be gun to change in a number of ways The increased attention given to the Japanese consumer the pervasive role of the Japanese state in the economy and distinctive private business practices are changing The system of lifetime employment and senioritybased pay is weakening because of recession and the increasing need in the information economy to reward the most valued younger workers some firms have even been forced to lay off tens of thousands of workers Under severe financial pressure some keiretsu have begun to unravel as members have been forced to sell off their holdings in member firms Corporate mergers and restructuring are still limited by Western stan dards but are increasing Renaults takeover of Nissan could never have occurred in the past A significant increase in foreign direct in vestment and in the number of foreigners in the economy has taken 189 C H A P T E R S E V E N place Younger Japanese have become much more entrepreneurial Throughout the economy an increasing emphasis on return to equity has caused firms to decrease their former concern with market share The pressure for profitability and reform will increase as pension funds demand greater returns to support the growing population of the aged High wages production costs and an overvalued yen are forcing Japanese firms to produce more and more goods in overseas plants The core of the Japanese industrial economy is the main bank system In the early postwar years this system was very effective in collecting national savings and funneling them to the industrial mem bers of the keiretsu However this system resulted in overly close bankingindustry ties and led to major inefficiencies corruption and other abuses The main bank system that once pumped capital into keiretsu regardless of risk has failed it was this system that led to the colossal misallocation of capital that culminated in Japans bubble economy Largely as a consequence of the collapse of the bubble and the ensuing financial crisis the main bank system has been under strain and has been undergoing major reforms In addition financial reforms of the late 1990s have increased competition especially from American and other financial institutions and have been forcing Jap anese banks to become more prudent lenders and more profit oriented in their practices Nevertheless powerful banks and the Ministry of Finance can be expected to remain major forces in the Japanese financial system Despite these impressive changes in Japans political economy there has been no significant alteration in such fundamental aspects of the economy as the political domination of the country by a con servative political business and bureaucratic elite Japans neomer cantilist exportled growth strategy has not changed nor has the closed nature of the keiretsu been altered Fundamental change will succeed only when and if Japan moves decisively in the direction of a more marketoriented economy Such a transformation would require greatly expanded deregulation of the economy and the Japanese economy is still the most regulated among industrialized countries The overregulation of the economy by government bureaucracies has stifled innovation discouraged entrepreneurship and caused gross in efficiencies Deregulation of the economy would stimulate entrepre neurship and increase productivity it would also be an important step toward opening the Japanese market to imports and this would further increase overall efficiency 190 S Y S T E M S O F P O L I T I C A L E C O N O M Y Meaningful deregulation of the Japanese economy will be ex tremely difficult to achieve The power of domestic interests that seek protection and the emphasis on social harmony and safeguarding the weak have contributed to overregulation Reform and deregulation would entail closing thousands of firms and putting hundreds of thousands of Japanese out of work therefore it is almost a certainty that public and vested interests will remain overwhelmingly opposed to such action Moreover as deregulation would weaken the power of the Ministry of Finance and other powerful bureaucracies these agencies would also oppose any drastic reforms It is instructive to note that the Japanese have a quite different concept of deregulation than does the United States Whereas Americans interpret deregula tion to mean the elimination of rules and regulators the Japanese word for deregulation kisei kanwa means relaxation of regulation and not elimination 57 Even though the rules may be changed the Japanese bureaucracy will still attempt to regulate the system Never theless the task of regulation has become increasingly difficult as Jap anese firms have become more powerful and as success in catching up with Western technology has led to a diminished role for central planning and bureaucratic control As the Japanese are well aware they must become technological innovators and this requires some drastic changes in their society Most American economists and public officials believe that the so lution to Japans economic problems is to transform Japan into an Americantype of freemarket economy However the Japanese like other Asians and most continental Europeans are fearful of the possi ble consequences of adopting completely the American shareholder system Most Japanese and Europeans reject the AngloSaxoniza tion of the economy as a threat to social peace and in the case of the Japanese to economicpolitical independence Japanese society they fear would be torn apart by the ruthlessness considered typical of the American economy and its toleration of high levels of economic insecurity and a large number of losers For these reasons Japan strongly resists conversion to the American economic model More importantly changing Japan into a Westernstyle economy would en tail a fundamental shift in the relationships between individuals and society there would have to be much greater emphasis on individual ism and some of the tight social bonds that are so characteristic of Japanese society would have to be weakened These hurdles mean 57 Bernstein Japanese Capitalism 484 191 C H A P T E R S E V E N that Japan is quite unlikely to become an Americantype market economy Harmonization Another possible solution to the problem posed by national differ ences is harmonization Whereas the theory of economic convergence assumes that time and the market will lead to a blurring of national differences the harmonization approach maintains that eradication of significant national differences should be an explicit goal of inter national negotiations Many areas of government policies that lend themselves to harmonization already fall within the province of the World Trade Organization and other international institutions The doctrine of national treatment embodied in the GATTWTO for ex ample prohibits discriminatory taxes and regulations to be applied to foreign firms The Tokyo Uruguay and other GATT Rounds of trade negotiations have resolved many vexing issues that arise from cultural historic and government regulatory traditions All these achievements however are only a small step toward a solution of the problem The first major effort toward negotiated harmonization of national differences was made in the Tokyo Round of trade negotiations by the mid1980s the concept of reciprocity or more pointedly specific reciprocity had become the principal mechanism employed to achieve greater harmonization among national systems of political economy Under the GATT and to a lesser extent under the WTO system general reciprocity had been the rule nations would make broad concessions to trading partners in exchange for other broad concessions Underlying this negotiating tactic was an assumption that over time concessions from one country to another would bal ance out and everyone would benefit from a more open international economy Rightly or wrongly by the mid1980s the United States and Western Europe believed that general reciprocity was working too slowly the United States in particular believed that its trading partners read especially Japan had failed to carry out the agreements to which they had committed themselves Therefore in place of gen eral reciprocity the United States and Western Europe resorted to a policy of specific reciprocity under which these nations would not make any concessions and might even withdraw prior concessions if the other party did not fulfill its side of the agreement this position was the rationale for the 1990s American policy of managed trade toward Japan in which the United States demanded a percentage of the Japanese market in automobiles and other products in exchange 192 S Y S T E M S O F P O L I T I C A L E C O N O M Y for Japanese access to the American market Needless to say Japan and other countries that have been the object of such treatment have deeply resented it and regard specific reciprocity as an unwarranted interference in their domestic affairs Whatever the merits of specific reciprocity it is one tool for dealing with the increasingly important clash between national systems of political economy and the threat that these national differences pose to maintenance of an open world economy The most contentious issues lie outside the jurisdiction of interna tional organizations and governments everywhere prefer that no in ternational organization should have the authority to enact enforce or prescribe universal rules or regulations for conducting business Every government prefers to leave such matters in its own hands At the same time however every government and certainly every busi ness firm would like those government regulations economic struc tures and private business practices that constrain the activities of its own firms in foreign markets to be eliminated This objective of transforming the regulations and business practices of foreign govern ments has been aggressively pursued by the United States and to a lesser extent by Western Europe Competition policy is one critically important policy area that lies outside the jurisdiction of existing international institutions and that has become a source of increasing friction Economists concerned with competition policy refer to restrictive business practices that pose an obstacle to economic growth trade expansion and other eco nomic goals Competition policy applies to those domestic economic policies and regulations that determine legal or legitimate forms of business behavior and practices such policies have become significant points of contention between the United States and the developmental states of East Asia The antitrust tradition that attempts to prevent collusive business practices and concentration of corporate power is the essence of competition policy in the United States and it facili tates entry into the American economy by foreign firms Japanese and South Korean competition policies on the other hand not only toler ate but actually encourage concentration of corporate power in the form of the keiretsu and the chaebol Although both these institutions are troubled at the opening of the twentyfirst century it is unlikely that they will be dismantled in the name of increased openness and competition Can harmonization and the policy of specific reciprocity work rap idly and effectively enough to overcome the political problems raised by national differences Successive American Administrations have 193 C H A P T E R S E V E N believed that the process of economic convergence and reliance on multilateral negotiations to overcome problems of policy structural and behavioral differences work much too slowly Many reason that the United States and its more open and competitive economy suffer from efforts to pursue goals in this fashion Thus Americans have supported a policy of enforced harmonization and where this tactic has failed of protectionism As has already been mentioned the most notable or infamous example of this approach was the prolonged and acrimonious Structural Impediments Initiative SII negotiations be tween Japan and the United States These negotiations in which the United States sought to transform important aspects of the Japanese economy achieved little and left a bitter residue in Japan Mutual Recognition The most simple approach to the problem of national differences is mutual recognition According to this principle every nation should accept the legitimacy of the rules by which other nations manage their economies For example a multinational firm establishing a subsid iary in another economy should be free to behave as it does in its own economy This approach has been adopted by the European Union Except in a few basic areas such as health and national stan dards the members of the Union have agreed to permit businesses to operate throughout Western Europe in accordance with the laws and regulations of their home country Thus the subsidiary of a German corporation doing business in France would be governed principally by German law nevertheless more and more business regulations are being formulated in Brussels The fundamental question of course is whether or not the princi ple of mutual recognition is applicable to other parts of the world The principle is particularly well suited to Western Europe for a num ber of reasons Continental Europe inherited the Roman and Napole onic legal and administrative traditions and as Peter Katzenstein has pointed out the nations of continental Europe share a concept of the limited state that is the state is regarded as an impartial and indepen dent entity separate from society but responsible for creating a favor able and impartial environment for private business Economic and cultural differences among the European nations are minor when compared to those in any other regions of the globe Also during the postwar era the processes of deregulation privatization and liberal ization have reduced the role of the state in the economy and harmo nized to a considerable degree the economic structures and business practices across the Continent Both the historic traditions and other 194 S Y S T E M S O F P O L I T I C A L E C O N O M Y developments in Western Europe have facilitated adoption of the principle of mutual recognition as an expeditious means to promote the economic unification of the Continent Needless to say the conditions that exist in Western Europe do not exist anywhere else in the world Within the North American Free Trade Agreement area although the United States and Canada are very close in almost every aspect of national life there is an enormous gap between these countries and Mexico in many respects the princi ple of mutual recognition is hardly applicable to NAFTA or to rela tions between North and South America The economic cultural and political diversity in the AsiaPacific area is even more striking The principle of mutual recognition cannot serve as a means toward the economic and political integration of that region and certainly cannot provide the basis for a resolution of differences between the West and these rising economic powers At the heart of the problems is the fact that economic and political affairs are intimately joined to one an other It is therefore difficult to isolate the economy from the polity so that the former may function according to the principles of neo classical economics Moreover if one incorporates religion as a vitally important element in many of these states as it is in the Middle East application of the principle of mutual recognition as a solution to the problem of national differences becomes totally out of the question Conclusion In the early years following the end of the Cold War there was a prevalent belief that the clash between capitalism and communism would be replaced by a clash between rival forms of capitalism This belief at least thus far has been proved wrong Yet it is obvious that increasing interdependence of national economies has made legal policy and structural differences among national societies both more important and frequently also a source of tension and occasional po litical conflict Differing national systems of political economy consti tute a serious obstacle to the movement toward an even more open multilateral global economy Differences in such matters as competi tion policy business practices and corporate structures have become major concerns of international trade and other negotiations 195 CHAPTER EIGHT The Trading System E CONOMISTS OF every persuasion are convinced that free trade is superior to trade protection 1 In fact they consider free trade to be the best policy for a country even if all other countries should practice trade protection arguing that if other countries resort to trade protection the economy that remained open would still gain more from cheaper imports than it would lose in denied export mar kets Despite this powerful inclination within the economics profes sion to favor free trade and open markets trade protection has never totally disappeared and indeed during the past two centuries re stricted trade has been a pervasive feature of the world economy As economic historian Paul Bairoch has pointed out free trade has historically been the exception and protectionism the rule 2 Although nations want to take advantage of foreign markets they are fre quently unwilling to open their own economies Nations and domes tic interests alike fear a world in which market forces rule and relative prices determine the patterns and distribution of the gains from trade Throughout modern history trade has been regarded either as an in ternational public good from which everyone benefits or a battle ground in which there are winners and losers 3 Even though the argu ment for free trade is powerful trade protectionism continuously resurfaces in new guises 4 The classic era of free trade and international laissezfaire lasted less than three decades from the repeal of the Corn Laws 1846 to approximately the 1870s when protectionist tariffs increased From the latter decades of the nineteenth century to the years immediately 1 This chapter draws from Chapter 3 of my book The Challenge of Global Capital ism The World Economy in the 21st Century Princeton Princeton University Press 2000 2 Paul Bairoch Economics and World History Myths and Paradoxes New York Harvester Wheatsheaf 1993 16 3 John Dunn quoted in Vincent Cable The Diminished NationState A Study in the Loss of Economic Power in What Future for the State Daedalus 124 no 2 spring 1995 25 4 A valuable history of the debate over free trade is Douglas A Irwin Against the Tide An Intellectual History of Free Trade Princeton Princeton University Press 1996 196 T H E T R A D I N G S Y S T E M following World War II trade protection grew steadily and became increasingly prevalent up to and during the Great Depression of the 1930s Following World War II the world again experienced an era of trade liberalization and expansion largely as a consequence of suc cessive rounds of trade negotiations carried out under the auspices of the General Agreement on Tariffs and Trade GATT and strongly supported by American leadership International trade grew even more rapidly than did national economies Consequently interna tional trade integrated national economies more closely with one an other In the mid1970s global stagflation the New Protectionism and other developments slowed and in some cases reversed this lib eralization trend 5 The United States was particularly guilty of New Protectionism in its use of such nontariff barriers as voluntary ex port restraints to keep out Japanese and other imports Major steps were taken toward further trade liberalization with new rounds of trade negotiations and particularly with the successful completion of the Uruguay Round of trade negotiations 1993 The Uruguay Round created the World Trade Organization WTO to replace the increasingly obsolescent GATT However new threats also surfaced in the form of managed trade economic regionalism and a new trade agenda dealing with such problems as fair labor standards and environmental protection Tension between free trade and trade protection has continued and the future of a freetrade regime remains precarious At the opening of the twentyfirst century the freetrade regime is threatened by intellectual economic and political developments The shift from comparative to competitive advantage as the basis of trade the implications of the new strategic trade theory and other developments have undermined the theoretical or intellectual argu ments for trade liberalization Increasing trade penetration into do mestic economies and national affairs has forced recognition of such complex problems as formulation of definitions of fair and legiti mate economic behavior that which is considered fair in one soci ety may be considered unfair in another Trade issues have become focused on culture national sovereignty and other complex issues that are not easily amenable to bargaining and compromise solutions In addition political opposition to trade liberalization has grown among many groups concerned about worker welfare the environ ment and human rights Many less developed nations now believe 5 H Richard Friman Patchwork Protectionism Textile Trade Policy in the United States Japan and West Germany Ithaca Cornell University Press 1990 197 C H A P T E R E I G H T that the trading system functions to their disadvantage It is particu larly noteworthy that the three major trading powersthe United States Western Europe and Japanbecame convinced that the polit ical costs of lowering certain trade barriers in response to demands from one or another major power had become unacceptable These several obstacles to further trade liberalization reached a crisis point at the November 1999 meeting of the WTO in Seattle The Debate over Free Trade The liberal doctrine of free trade is based on the principles of the market system formulated by classical economists Adam Smith and David Ricardo argued that removing the impediments to the free movement of goods would permit national specialization and facili tate optimal utilization of the worlds scarce resources Trade liberal ization would lead to efficient trade patterns determined by the princi ple of comparative advantage that is by relative factor prices of land capital and labor Adoption of the principle of comparative advantage or comparative cost would ensure that a country would achieve greater economic welfare through participation in foreign trade than through trade protection Underlying this liberal commit ment to free trade is the belief that the purpose of economic activity is to benefit the consumer and maximize global wealth Free trade also maximizes consumer choice reduces prices and facilitates effi cient use of the worlds scarce resources From this perspective the primary purpose of exports is to pay for imports rather than to en hance the power of the state According to its advocates trade liberalization produces a number of specific benefits In the first place trade liberalization increases competition in domestic markets and thereby undermines anticom petitive practices lowers prices increases consumer choice and in creases national efficiency In addition free trade increases both na tional and global wealth by enabling countries to specialize and to export those goods and services in which they have a comparative advantage while importing those goods and services in which they lack comparative advantage Free trade also encourages the interna tional spread of technology and knowhow around the globe and thus provides developing economies with the opportunity to catch up in income and productivity with more advanced economies Last but not least free trade and the international cooperation that it entails increase the prospects of world peace Ever since Adam Smiths attack on mercantilism in The Wealth of Nations 1776 economists have rejected trade protection because of 198 T H E T R A D I N G S Y S T E M its high costs to an economy and there are many empirical studies strongly criticizing trade barriers 6 For example a study by Gary Clyde Hufbauer and Kimberly Ann Elliot published in 1994 in the context of the bitter controversy over the ratification of the North American Free Trade Agreement NAFTA found that past protec tion of twentyone American industries had actually saved few jobs and that the cost to consumers had been approximately 170000 per job saved The equivalent figure for Japan is 600000 While one may quarrel with the precision of these figures it is indisputable that trade protection constitutes a heavy burden on an economy 7 Trade protection also has a negative impact on income distribution A tariff or other restrictive measure creates economic or monopoly rents and shifts income from consumers and nonprotected sectors to the protected sectors of the economy American restrictions in the late 1980s on the importation of flat panels and memory chips for com puters provide an excellent example of the cost to American consum ers and the harm done to other industries by protection of one partic ular industry In this example import restrictions raised costs for American computer makers and thus made them less competitive re strictions on importation of flat panels led Apple Computer to shift production of its then popular Powerbook computer overseas Para doxically some types of import protection can even shift income from domestic consumers and producers to foreign producers A notable example was the imposition of voluntary export restraints on Japa nese automobile imports into the United States in the early 1980s This action proved very advantageous for the Japanese automobile industry at the same time that it decreased the competitive stimulus to the American automobile industry Finally one of the most serious dangers of trade restrictions is that they tend to protect declining non competitive industries The one important exception to economists universal belief in the superiority of free trade over trade protection is the protection of infant industries 8 Many economists I believe accept the argument first set forth by Alexander Hamilton that nourishing infant industries 6 Adam Smith An Inquiry into the Nature and Causes of the Wealth of Nations New York Modern Library 1937 1776 7 Gary Clyde Hufbauer and Kimberly Ann Elliot Costs of Protection in the United States Washington DC Institute for International Economics 1994 8 Another alternative to free trade is the imposition of an optimum tariff Under certain circumstances a large country can impose a trade barrier that improves its terms of trade to the disadvantage of its trading partners However the gains will probably be too small to warrant the risk to the trading system and political conse quences 199 C H A P T E R E I G H T can provide an acceptable rationale for trade protection An infant industry is one that if protected from international competition will become sufficiently strong and competitive to enable it to survive when protection is eventually removed A major problem with infant industry protection however is that protection too frequently be comes permanent Another important problem is that no theoretical or other means exists to determine whether or not a particular infant industry if protected could eventually achieve a competitive position in world markets Only a trialanderror process can determine the longterm competitiveness of a protected industry Nevertheless as I pointed out in chapter seven most successes attributed to industrial policy and strategic trade policy are really examples of successful in fantindustry protection From eighteenthcentury mercantilists to presentday protection ists advocates of trade protection have desired to achieve certain po litical economic and other objectives more than the economic bene fits for the entire society of free trade However the specific objectives sought by protectionists have varied over time and space Economic nationalists regard trade protection as a tool of state creation and statecraft for example a trade surplus is considered beneficial for national security Many representatives of less developed countries believe that trade with industrialized countries is a form of imperial ism they fear that free trade benefits only the developed economy and leads to dependence of the less developed countries on the devel oped ones Opponents of free trade in developing economies also in clude advocates of the developmental state who believe that the state rather than free markets should have the principal role in the process of economic development In developed economies propo nents of trade protection reject free trade and other forms of global ization as threats to jobs wages and domestic social welfare orga nized labor in industrialized countries increasingly advocates protection against imports from lowwage economies with inade quate labor standards In recent decades more and more environmen talists have denounced trade as a threat to the environment Many liberals in the American sense of the word have come to believe that trade violates human rights and encourages child labor Unfortu nately the forces in developed countries that are opposed to free trade especially in the United States gained considerable momentum in the 1990s The most systematic economic rationale for economic nationalism and trade protection was provided by Friedrich List a German who fled to the United States in the middle of the nineteenth century to 200 T H E T R A D I N G S Y S T E M avoid political persecution Strongly influenced by Alexander Hamil tons protectionist ideas List argued in his National System of Politi cal Economy 1841 that every industrial nation has pursued and should pursue protectionist policies in order to safeguard its infant industries 9 List maintained that once their industries were strong enough to withstand international competition these countries low ered their trade barriers proclaimed the virtues of free trade and then sought to get other countries to lower their barriers Free trade List believed was the policy of the strong If one were to translate Lists ideas into modern parlance one would say that every successful industrial power at some point in its history has carried out an activ ist industrial policy 10 At the beginning of the twentyfirst century many trade protection ists advocate promotion through national industrial policies of high tech and certain other favored sectors in order to build the nations industrial strength and increase its competitiveness They believe that the state should guide and shape the overall industrial and technologi cal structure of the society through trade protection industrial policy and other forms of government intervention In addition to such high tech industries as computers and electronics economic nationalists also favor support for more traditional manufacturing industries such as the automobile and other massproduction industries characterized by high valueadded and high wages Although in its efforts to catch up with the West Japan has conspicuously and aggressively pursued an industrial policy industrial policies have also been employed by the United States Western Europe and many developing economies to promote industries believed important for national security and economic development Economists have strongly disputed the alleged benefits of trade pro tection 11 Trade protection they point out reduces both national and international economic efficiency by preventing countries from ex porting those goods and services in which they have a comparative advantage and from importing those goods and services in which they lack comparative advantage Protection also decreases the incentive of firms to innovate and thus climb the technological ladder it also discourages shifting national resources to their most profitable use 9 Friedrich List The National System of Political Economy New York Longmans Green 1928 first published in 1841 10 Support for Lists position comes from Paul Bairoch Economics and World His tory Myths and Paradoxes Chapter 4 11 An outstanding critique of protectionist arguments for protection is W Max Cor den Trade Policy and Economic Welfare Oxford Clarendon Press 1974 201 C H A P T E R E I G H T As David Hume 17111776 demonstrated protectionism decreases exports over the long term Although erecting trade barriers can im prove exports temporarily this improvement causes the value of the currency to rise thus undercutting competitiveness protectionism can also increase the cost of inputs and that decreases competitiveness over the long term The protectionist argument that competition from lowwage economies lowers wages and causes unemployment in in dustrialized economies is rejected by most economists they point out that the principal cause of the economic plight of unskilled workers in the developed economies is the rapid technological change caused by the computer and the information economy both of which favor highly skilled workers The major consequence of protectionism economists argue is redistribution of national income from consum ers to protected producer interests Finally trade protection invites retaliation from other countries and this means that everyone will lose Despite economists arguments supporting trade liberalization trade protectionism persists and its advocates too frequently succeed Endogenous trade theory explains the success of protectionism by calling attention to the fact that the political process generally favors special interests desiring protection rather than general consumer in terests Whereas the benefits of free trade diffuse across a society the benefits of protection are concentrated in a few groups of producers This situation provides motivation for producers to organize in order to influence public policy and thus gain protection 12 As the Wall Street Journal has quipped The first rule of trade agreements is that the benefits are widely dispersed the costs are very concentrated and the losers are very vocal 13 Trade and the Economy Not only is the debate over free trade inconclusive but also there are several misunderstandings regarding what trade does and does not do and these misunderstandings have fueled protectionist rhetoric They have also contributed to negative attitudes in the United States and elsewhere about economic globalization and its alleged conse quences for the economy 12 On the political economy of trade consult John S Odell and Thomas D Willett eds International Trade Policy Gains from Exchange between Economics and Politi cal Science Ann Arbor University of Michigan Press 1990 13 Wall Street Journal 6 December 1999 A1 202 T H E T R A D I N G S Y S T E M One pernicious misunderstanding in the United States at the open ing of the twentyfirst century is the idea that a nations trade deficit is due to the unfair trade practices of a countrys trading partners Obviously some countries do cheat and gain temporary advantage in trade However a chronic trade deficit like the one the United States experienced during much of the last quarter of the twentieth century was due to macroeconomic factors and not to cheating by trading partners The tradepayments balance of a country is a result of a nations spending patterns and is due in particular to the difference between national savings and domestic investment A country with a high savings rate relative to its investment rate will have a tradepay ments surplus On the other hand a nation with a savings rate that is low relative to its investment rate will have a tradepayments defi cit The behavior of a nations trading partner does not affect the formers tradepayments balance In the 1980s and 1990s the huge and persistent tradepayments deficit of the United States was due primarily to the low rate of American savings Nevertheless incor rectly blaming Japan for the deficit in the early 1990s the Clinton Administration launched an aggressive attack on Japan as an unfair trader 14 Another and equally unfortunate misunderstanding is the belief that imports from lowwage developing countries are responsible for increasing wage inequality in the United States and for unemployment in Western Europe Most economists agree on the facts regarding in come inequality in the United States Late in the twentieth century income inequality increased significantly Between the end of World War II and 1973 rapid economic and high productivity growth did raise income uniformly for Americans of all income brackets and incomes approximately doubled Between 1973 and the mid1990s however the pace of income growth slowed and income inequality increased Whereas median family income increased 10 percent be tween 1973 and 1999 income in the highest bracket 95th percentile grew more than a third while income in the lowest income grouping 20th percentile remained virtually unchanged especially for women The real earnings of many lowwage and middleclass workers stag nated or experienced only modest gains while the wealthier 20 per cent of American families gained greatly In brief after the 1970s the standard of living of many American workers grew very slowly while income inequality increased considerably 14 This subject is discussed in Gilpin The Challenge of Global Capitalism Chapter 8 203 C H A P T E R E I G H T A large number of Americans particularly organized labor blame manufactured and other imports from lowwage economies for in come inequality and job insecurity and demand restrictions on im ports Protectionists like Ross Perot and Patrick Buchanan have asked how an American worker earning 20 or more an hour could possi bly compete against billions of Chinese Indians Indonesians and Bangladeshi earning less than 20 an hour This unfair competition from lowwage countries many proclaim has been rapidly advancing up the technological ladder so that it is harming a growing number of whitecollar workers India for example has become a worldclass center of data processing and software development Globalization has also increased immigration of workers from poorer countries into the advanced industrial countries workers who then take jobs away from local workers Therefore many critics of globalization charge that increased trade flows runaway plants of American multinational firms and immigration are responsible for the deterio rating economic plight of more and more workers in the United States Most American economists have disputed these charges and attrib uted almost all of the relative decline in the wages of lowskilled American workers to technological changes within the American economy itself Technological advances such as the computer and in formation economy they have argued significantly decreased the de mand for lowskilled workers and greatly increased the demand for skilled especially collegeeducated workers Furthermore these economists have noted that the relatively small trade flows between the United States and lowwage economies cannot possibly explain the roughly 30 percent difference in wages between skilledcollege educated and unskilled workers in America Instead this decline in the wages of lowskilled workers has been due to such technological developments as automation lean production techniques and com puterization At the beginning of the twentyfirst century advanced economies are rapidly shifting from unskilled bluecollar laborintensive indus tries to service industries and to greater reliance on skilled labor in manufacturing as well as in other aspects of economic life This struc tural change parallels the shift from agriculture to manufacturing in the late nineteenth century when as agriculture became more mecha nized superfluous farm workers migrated from the land to the fac tory In the late 1990s many of the tasks formerly performed by unskilled and less skilled workers were being carried out by comput ers and automated processes The new service and knowledgebased 204 T H E T R A D I N G S Y S T E M industries require more highly skilled workers than in the past and this means that the demand for unskilled workers has declined dra matically throughout the American economy The semiskilled assem blyline worker in Detroit or Cleveland who once commanded a high wage in the automobile and other massproduction industries is in deed becoming superfluous in the information economy British economist Adrian Wood disagrees with this consensus among economists and points out that competition from lowwage countries has stimulated laborsaving technological change in the United States and thereby reduced the demand for lowwage labor 15 Although viewed from this perspective some of the effects on wages attributed to technological changes can be attributed to trade compe tition from lowwage economies it is highly doubtful that imports from lowwage economies are as significant as opponents of global ization have claimed It is certain that trade protection is not a wise solution to the problems of stagnant wages income inequality and job insecurity The solution lies in jobtraining programs and other programs to aid adjustment to rapidly changing economic and tech nological developments In the 1990s the issue of trade and unemployment became impor tant in both Western Europe and the United States In Europe a high rate of longterm or structural unemployment had emerged in the 1970s particularly in southern Europe France and even Germany The overall rate of unemployment in Western Europe in the 1990s had reached approximately 10 to 12 percent more than twice that of the United States In some countries the rate climbed over 20 percent Not surprisingly it became almost an article of faith among business political and intellectual leaders that imports from lowwage econo mies were responsible for this situation In the United States the issue became inflamed during the debate over the ratification of the North American Free Trade Agreement NAFTA Some political leaders especially Perot and Buchanan along with organized labor pro claimed that the agreement would result in the loss of millions of American jobs The Clinton Administration after considerable vacil lation maintained that the agreement would create jobs jobs jobs Both positions were wrong A countrys unemployment rate is determined principally by its macroeconomic policies Through fiscal and monetary policies the developed countries in Western Europe and the United States can 15 Adrian Wood NorthSouth Trade Employment and Inequality Changing For tunes in a SkillDriven World Oxford Clarendon Press 1994 205 C H A P T E R E I G H T within certain limits manage a nations rate of unemployment In a wellfunctioning economy trade does not decrease or increase unem ployment While NAFTA has not affected the number of jobs in the American economy it has redistributed jobs from one economic sec tor or region of the country to others In Western Europe the high rate of unemployment has been a consequence of several factors in flexible labor markets overly generous welfare programs that dis courage expanded employment and highly restrictive macroeconomic policies associated with meeting the requirements for nations to join the European Monetary Union Domestic factors and not interna tional trade have been the major causes of Western Europes high level of chronic unemployment Trade however does create losers as well as winners in the areas of both wages and employment Economic sectors in which a nation possesses or wins a comparative advantage gain from trade while sectors in which a nation loses comparative advantage suffer As los ers frequently feel the pain more acutely than winners feel the gain both ethical and political reasons make it necessary that national pol icy assist or compensate workers and others harmed by trade liberal ization In any case the worst response a nation can make to inevita ble shifts in comparative advantage is to close itself off from the stimulus of trade competition Revisions of Conventional Trade Theory Since its development in the early 1930s by Eli Heckscher and Bertil Ohlin the factor endowments or factor proportions model has been accepted as the standard explanation of international trade The HeckscherOhlin or HO model of comparative costs or advantage postulates that a country will specialize in the production and export of those products in which it has a cost advantage over other coun tries This theory is based on assumptions of constant returns to scale universal availability of production technologies and determination of a countrys comparative advantage and trade pattern by its factor endowments 16 This theory implies that 1 A country will export those products that are intensive in its abundant factor that is a capitalrich country will export capi talintensive goods 16 This section draws on Ronald Rogowskis highly innovative paper entitled How EconomiesofScale Trade Affects Domestic Politics Center for International Rela tions Working Papers No 13 May 1997 University of California Los Angeles 206 T H E T R A D I N G S Y S T E M 2 Trade will benefit the owners of locally abundant factors and harm owners of the scarce factors Thus although all countries will benefit in absolute terms there will be important distributive consequences that will favor either capital or labor in trading countries StoplerSamuelson Theorem 3 Trade in factors capital or labor and trade in goods will have the same effect and can fully substitute for one another Mundell equivalency 4 Under certain circumstances trade in goods will over time equal ize the return wages to labor and profits to capital for each factor of production FactorPrice Equalization Theorem The basic problem with the HO model or theory is that actual trading patterns frequently differ from what the theory predicts A notable example is found in intraindustry trade among countries with similar factor endowments Indeed most trade among industrialized countries takes place largely in the same product sectors for example the United States both exports to and imports from other industrial ized countries As a consequence of the efforts by economists to ex plain this and other departures from the HO theory the concept of comparative advantage has been made increasingly elastic Some economists regard actual trade patterns as resulting from many fac tors other than natural endowments factors including historical acci dents government policies and cumulative causation Moreover the standard HO theory itself has been modified and expanded to in clude such important factors as human capital skilled labor learn ing by doing technological innovation and especially economies of scale Revisions have so transformed the original HO model that some economists now argue that the theory of international trade is not much more than an eclectic enumeration of the many factors that determine comparative advantage and trade flows However it is very difficult to incorporate these newly recognized factors into a formal model and because there is no satisfactory alter native model economists continue to support the standard HO the ory of trade based on factor endowments As Richard Caves and Ronald Jones have argued the HeckscherOhlin theory with its em phasis on factor endowments is still largely valid 17 Moreover as economists argue national specialization and the benefits of a territo rial division of labor remain valid concepts that are of overwhelming 17 Richard Caves and Ronald Jones quoted in David B Yoffie and Benjamin Gomes Casseres International Trade and Competition Cases and Notes in Strategy and Man agement 2d ed New York McGrawHill 1994 8 207 C H A P T E R E I G H T importance for the efficient use of the worlds scarce resources True But this generalization does not explain or determine which country will produce what and nationstates will always be very reluctant to leave that decision entirely up to the market Concept of Human Capital An especially important modification of trade theory followed Was sily Leontiefs discovery of the Leontief Paradox 18 In his research Leontief discovered that the United States had a comparative advan tage in exporting laborintensive goods especially agricultural prod ucts and other commodities This empirical finding ran counter to the prediction that the United States as a capitalrich country would have a comparative advantage in capitalintensive goods According to the StoplerSamuelson theorem derived from conventional trade theory a country will export goods produced by its most abundant factor of production and import goods made by its least abundant factor The paradox or anomaly that Leontief found in American exports was eventually resolved by introduction of the concepts of human capi tal and of economies of scale into both trade theory and the neoclas sical theory of economic growth 19 Recognition of the importance and effect of investment in training education and knowhow in the United States and of the resulting increase in the skills and productiv ity of American workers explained the Leontief Paradox While the idea of human capital considerably enriched and extended our under standing of international trade it did make the original HO theory less rigorous or as economists would say less robust Rise of Intraindustry Trade Since the reconstruction of Western Europe and the freeing of trade through successive GATT negotiations most trade has taken place contrary to the HO theory between countries with similar factor endowments most exports of industrialized economies go to other industrialized countries Such intraindustry trade entails an econo mys exporting and importing goods in the same economic sectors as in exportation of one type of automobile and importation of another type Interindustry trade on the other hand entails exporting and importing goods in very different economic sectors such as exporting manufactured goods and importing raw materials Intraindustry trade 18 Wassily W Leontief Domestic Production and Foreign Trade The American Capital Position Reexamined Economia Internazionale 7 no 1 1954 332 19 William A Kerr and Nicholas Perdikis The Economics of International Business London Chapman and Hall 1995 2426 208 T H E T R A D I N G S Y S T E M has been a prominent feature of northnorth trade whereas interin dustry trade has tended to characterize northsouth trade How can this type of trade among advanced industrialized economies be ex plained The HeckscherOhlin model predicts that most trade should take place among countries with dissimilar endowments and that intrain dustry trade should not even exist If comparative advantage and trade patterns are determined by fixed endowments and relative prices why should the industrial countries in effect be taking in one anothers laundry This anomaly can be explained by differing na tional tastes product differentiation and economies of scale Ameri cans for example traditionally like big cars and Europeans small ones Americans have tended to possess a comparative advantage in the former and Europeans in the latter Yet there is a market in the United States for small European cars and vice versa Since the impor tance of intraindustry trade was recognized the HeckscherOhlin model has been applied primarily to trade between developed and less developed countries and not to the intraindustry trade based on prod uct differentiation and scale economies that is characteristic among industrial countries However here another anomaly is encountered Japan during most of the latter half of the twentieth century imported a remark ably small share of the manufactured goods that it consumes Unlike Western European and US trade only a small portion of Japanese trade has been intraindustry tradethat is a twoway flow of trade within particular industries For example whereas Japan was the worlds largest exporter of automobiles for many years its imports of automobiles and auto parts were negligible Instead even in the 1990s the pattern of Japanese trade continued to be largely interin dustry trade Japan was importing mainly food fuel and raw materi als and exporting mainly motor vehicles and other manufactures While this unique Japanese trading pattern began to change in the final years of the twentieth century it had long been a major source of economic conflict between Japan and its trading partners Integration of International Trade and Foreign Investment Another important development in the postwar era has been the in creasing integration of international trade and foreign direct invest ment FDI by multinational corporations MNCs When capital in the form of portfolio investment became increasingly mobile across borders in the late nineteenth century economists assumed that inter national capital movements were due to differences among countries in rates of return and in investment risk When foreign direct invest 209 C H A P T E R E I G H T mentfor example the establishment of a production facility by a firm of one nationality within another economybecame an increas ingly important feature of the international economy economists as sumed that FDI like portfolio investment was due to differences in interest rates and that exports and foreign production were in es sence perfect substitutes for one another This acceptance of the Mundell equivalency continues to pervade economists attitudes to ward FDI Recently a number of economists have begun to rethink the nature and significance of foreign direct investment and have ap plied industrial organization theory to the behavior of multinational firms and the determination of international trade patterns The increasingly important role of the MNC in the world economy has resulted in a significant movement toward internationalization of both services and industrial production Organization of service industries and of manufacturing on a regional or global basis has greatly affected the trading system A substantial proportion of world trade now takes place as intrafirm transfers at prices set by the firms and as part of global corporate strategies By the 1990s this type of managed trade had become a prominent feature in the international economy In the late 1990s over 50 percent of American and Japa nese trade was intrafirm trade The resulting trade patterns frequently do not conform to conventional trade theory based on traditional concepts of comparative advantage There is intense disagreement on the implications of FDIs increas ing importance for international trade and for the international distri bution of wealth and economic activities Assuming that investment and its trade effects are just another application of the law of compar ative advantage many if not most economists believe that FDI has only marginal implications for patterns of trade and that its distribu tive effects are primarily domestic Many noneconomists however believe that FDI and the activities of multinational corporations have an immense impact on patterns of international trade and on the dis tribution of wealthand I shall addpower In addition whereas most business economists believe that the MNC is above politics and facilitates the rational organization and utilization of the worlds scarce resources to everyones benefit critics believe that MNCs pur sue their own private interests andor those of their home countries to the detriment of everyone else From Comparative to Competitive Advantage Another important intellectual development that has undermined the HO theory of international trade is a shift among economists from 210 T H E T R A D I N G S Y S T E M emphasizing comparative to emphasizing competitive advan tage especially in hightech sectors International competitiveness and trade patterns frequently result from arbitrary specialization based on increasing returns rather than from efforts to take advantage of fundamental national differences in resources or factor endowment 20 This new thinking about the arbitrary or accidental nature of interna tional specialization and competitiveness emphasizes the increasing importance of technology in determining trade patterns 21 The in creasing importance of technology and of economies of scale has be come an important factor in corporate and national economic strate gies In 1966 Raymond Vernons product cycle theory of foreign direct investment incorporated technology into trade theory his work fore shadowed later writings on the importance of technological innova tion for trade and investment patterns 22 According to Vernon Ameri can FDI in the 1960s could be explained primarily as a result of Americas competitive advantage in product innovation and of the desire of American firms to deter or forestall the rise of foreign com petitors Additional influential work on the broad subject of the shift from comparative to competitive advantage has been produced by Michael Porter a professor at Harvard Universitys Business School Through his extensive research Porter has attempted to explain why the firms of some countries have been more competitive in specific industrial sectors than the firms of other countries 23 The United States for ex ample has been very strong in aircraft while Japan has had an ad vantage in consumer electronics and automobiles Through his de tailed and extensive empirical studies of the trading patterns of several countries Porter found determinants of such patterns at least among industrialized countries The central finding of Porters research was that the internal char acteristics of a national economy including what I have identified as the national system of political economy affect the environment of 20 Krugman Geography and Trade Cambridge MIT Press 1991 7 21 Robert M Solow Growth Theory in David Greenaway Michael Bleaney and Ian Stewart eds Companion to Contemporary Economic Thought London Routledge 1991 407 22 Raymond Vernon Sovereignty at Bay New York Basic Books 1971 and Ver non International Investment and International Trade in the Product Cycle Quar terly Journal of Economics 80 no 2 May 1966 190207 23 Michael E Porter The Competitive Advantage of Nations New York Free Press 1990 211 C H A P T E R E I G H T domestic firms in ways that either facilitate or obstruct development of competitive advantage in certain industries According to Porter several aspects of a national economy are particularly important the national culture and its influence on the purpose of economic activi ties the status of capital and labor the nature of effective demand the condition of supporting industries and the industrial structure of the economy These several factors Porter argues determine domestic competitive conditions and those conditions in turn influence the in ternational competitiveness of particular sectors of the economy Using specific industrial sectors as the units of analysis rather than the individual firm or the national economy as a whole Porter dem onstrates that an economy with a competitive advantage in a particu lar sector invariably has several strong firms in that sector Intense domestic competition among these oligopolistic firms confers on them their strong competitive position in international markets Thus for Porter the competitive advantage of Japanese firms in automobiles and consumer electronics is explained by the supercompetitiveness of the domestic market This supercompetition in Japan has been con centrated on winning market share rather than profit maximization and is carried out primarily through product innovation application of technology to productive processes and great attention to quality control rather than through the price competition characteristic of American firms Intense oligopolistic competition at the domestic level Porter concluded provided a better explanation of the interna tional competitiveness of Japanese firms in certain sectors than did any other factor certainly more than possible corporate collusion or government interventionist policies As a good economist Porter eschews the importance of the nation itself as a factor in international competitiveness However in fact Porter is talking about the importance of differences in national poli cies as an explanation of international competitiveness Although it was not his intention Porter actually demonstrates that national gov ernments do play an important role in helping or thwarting the efforts of firms to create competitive advantage Government policies can and do support or hinder the supplyanddemand factors affecting the success of particular sectors Furthermore governments can pro tect infant industries from international competition until they are strong enough to compete on their own and they can also foster technological innovation through support for R D assist domestic firms to gain access to foreign technology and protect proprietary knowledge from foreign competitors In short a government can take a longterm perspective and establish policies that foster a favorable 212 T H E T R A D I N G S Y S T E M domestic environment for those sectors most likely to be competitive in international markets As he substitutes the term competitive advantage for the tradi tional emphasis of neoclassical economics on comparative advan tage Porters research strongly supports the idea that advantage in international trade at least in hightech industries can be and is cre ated by deliberate corporate and national policies Comparative or competitive advantage results from deliberate corporate decisions and government policy choices rather than appearing as a gift from Mother Nature If international competitiveness is indeed increasingly based on technological developments learning by doing and econo mies of scale then individual firms are ultimately responsible for cre ating or failing to create competitive advantage but governments can and do have an important and even decisive role in promoting their own national firms in international markets Mainstream economists have been hesitant to acknowledge the in creased importance of such factors as technology and learning by do ing in the determination of trade patterns 24 Nevertheless the funda mental idea that comparative or competitive advantage is largely arbitrary and a product of human intervention rather than a fixed gift of nature is accepted by growing numbers of mainstream econo mists 25 Introducing the concept of knowledge capital as a determi nant of economic growth and international competitiveness Gross man and Helpman argue that comparative advantage results from natural endowments supported by experience 26 Moreover they em phasize that nations with a headstart in a particular technology tend to strengthen their position over time and that technologically deficit nations especially small nations may find it impossible to ever catch up 27 As the idea of path dependence teaches us productivity increases 24 Despite the importance of Michael Porters pioneering empirical studies his ideas appear to have had almost no impact on the American economics profession perhaps because the work is largely empirical and the findings cannot be expressed in a formal model 25 Gene M Grossman and Elhanan Helpman Trade Innovation and Growth American Economic Review 80 no 2 May 1990 86 26 Gene M Grossman and Elhanan Helpman Comparative Advantage and Long Run Growth American Economic Review 80 no 4 September 1994 796815 27 Gene M Grossman and Elhanan Helpman Hysteresis in the Trade Pattern in Wilfred J Ethier Elhanan Helpman and J Peter Neary eds Theory Policy and Dy namics in International Trade Essays in Honor of Ronald W Jones New York Cam bridge University Press 1993 288 The term hysteresis is used by economists to mean that an economic outcome has been determined by historical factors This is a rare concession to the role of history in economic outcomes 213 C H A P T E R E I G H T with cumulative experience and is determined to a considerable de gree by the initial pattern of specialization These important considerations that international comparative advantage in the production of and sale of hightechnology goods must be struggled for and earned through superior technological innovativeness has significantly intensified what F M Scherer has labeled international hightechnological competition 28 The drive for technological superiority has notably increased the receptivity of governments to the new trade theory New Trade Theory The most important and certainly the most controversial development challenging the conventional theory of international trade is the new trade theory more commonly known as strategic trade theory STT Therefore I repeat here much of my earlier discussion of stra tegic trade theory Strategic trade theory is the culmination of earlier challenges to conventional trade theory because it incorporates a growing appreciation of imperfect competition economies of scale economies of scope learning by doing the importance of R D and the role of technological spillovers STT is significant because it challenges the theoretical foundations of the economics professions unequivocal commitment to free trade In fact STT originated with the development of new analytical tools and growing dissatisfaction with conventional trade theory and its inability to explain the increas ing trade problems of the United States especially with respect to Japan in the 1980s 29 The application to trade theory of novel meth ods associated with important theoretical advances in the field of in dustrial organization provided the means to develop an alternative to the HO model Mathematical models of imperfect competition and game theoretic models were first incorporated into trade theory in the early 1980s by James Brander and Barbara Spencer 1983 two theorists of industrial organization 30 Before I consider the theory however I will discuss oligopolistic competition briefly 28 F M Scherer International HighTechnology Competition Cambridge Harvard University Press 1992 5 29 David B Yoffie and Benjamin GomesCasseres International Trade and Competi tion Cases and Notes in Strategy and Management 2nd ed New York McGraw Hill 1994 517 30 James A Brander and Barbara J Spencer International R D Rivalry and In dustrial Strategy Review of Economic Studies 50 1983 70722 214 T H E T R A D I N G S Y S T E M Under conditions of perfect competition strategic behavior is not possible because the behavior of one or just a few firms cannot sig nificantly change market conditions for other firms However if unit costs in certain industries do continue to fall as output increases economies of scale the total output of firms will expand but the number of firms will decrease Economies of scale in an industry mean that the market will support only one or just a few large firms that is the industry will become oligopolistic and the market will eventually be dominated by a few firms This would permit the behav ior of one firm to make a difference and to alter the decisions of other firms If imperfect or oligopolistic competition exists then monopoly rents or abnormally high profits can exist in that economic sector the resultant rents or superprofits could then be captured by a small num ber of firms or even by one firm Individual firms then may well pursue corporate strategies to increase their profits or economic rents Oligopolistic firms can and do consciously choose a course of ac tion that anticipates the behavior of their competitors If successful such action enables them to capture a much larger share of the market than would be the case under conditions of perfect competition For example oligopolistic firms can and do follow strategies in which they adjust their own prices and output in order to alter the prices and output of competitor firms Two of the most important strategies used to increase a firms longterm domination of an oligopolistic market are dumping selling below cost to drive out competitors in the product area and preemption through huge investment in pro ductive capacity to deter other entrants into the market Imperfect or oligopolisitc competition is most likely found in cer tain hightech industries characterized by economies of scale and learning by doing The sectors most likely to become oligopolistic include computers semiconductors and biotechnology these tech nologies of course are identified by most governments as the com manding heights of the information economy Many are dual tech nologies because they are very important to both military weaponry and to economic competitiveness Many countries consider it essential for both commercial and security reasons to take actions that will ensure a strong presence in some or all of these sectors The impor tance of a head start in these industries encourages firms to pursue a firstmover strategy so that cumulative processes and path depen dence will strengthen their market position The theory of strategic trade takes the existence of imperfect or oligopolistic competition one step further and suggests that a govern ment can take specific actions to help its own oligopolistic firms Gov 215 C H A P T E R E I G H T ernment policies can assist national firms to generate positive exter nalities eg technological spillovers and to shift profits from foreign firms to national firms Economists have long appreciated that a na tion with sufficient market power could enact an optimum tariff and thereby shift the terms of trade in its favor By restricting imports and decreasing the demand for a product a large economy may be able to cause the price of the imported good to fall Strategic trade theory however goes much farther than optimum trade theory in recogniz ing the capacity of a nation to intervene effectively in trade matters and thus to gain disproportionately A governments decision to sup port a domestic firms plans to increase its productive capabilities preemption or even to signal intention to build excess productive capacity exemplifies a strategic trade policy Through use of a direct subsidy to a firm or outright protection of a domestic industry the government might deter foreign firms from entering a particular in dustrial sector Since a minimum scale of production is necessary to achieve efficiency especially in many hightech industries the advan tage of being first firstmover advantage encourages a strategy of preemptive investment Strategic trade theory departs from conventional trade theory in its assumption that certain economic sectors are more important than others for the overall economy and therefore warrant government support Manufacturing industries for example are considered more valuable than service industries because manufacturing has tradition ally been characterized by higher rates of productivity growth and has produced higher profits higher valueadded and higher wages Some economic sectors especially such hightech industries as com puters semiconductors and information processing are particularly important because they generate spillovers and positive externalities that benefit the entire economy Because a new technology in one sector may have indirect benefits for firms in another sector firms that do extensive research and development are valuable to many oth ers However because firms may not be able to capture or appro priate the results of their research and development activities many will underinvest in these activities Proponents of strategic trade the ory argue that such a market failure indicates that firms should be assisted through direct subsidy or import protection particularly in hightech industries which frequently raise the skill level of the labor force and thus increase human capital If as the proponents of strate gic trade believe such special industries do exist then free trade is not optimal and government intervention in trade matters can increase national welfare 216 T H E T R A D I N G S Y S T E M Strategic trade theory has become a highly controversial subject within the economics profession Some critics argue that strategic trade theory is a clever flawed and pernicious idea that gives aid and comfort to proponents of trade protectionism Other opponents of the theory agree with this negative assessment and maintain that the theory itself adds nothing really new to dubious arguments favoring trade protection Perhaps in response to the severe denunciations of strategic trade theory by leading mainstream economists some of its earliest and strongest proponents have moderated their initial enthu siasm Many economists consider STT to be an intellectual game with no relevance to the real world of trade policy Despite these criticisms and recantations however strategic trade theory has had an impor tant impact on government policy and has undoubtedly been a factor in the slowdown in the growth of world trade What can be concluded about strategic trade theory and the indus trial policy to which it provides intellectual support The case for profit shifting from one economy to another has neither been proved nor disproved it is difficult to assess whether or not government in tervention in oligopolistic markets actually works because econo mists lack adequate models of the ways in which oligopolistic firms really behave and because the effects of trade policy in oligopolistic industries can depend to a critical degree on that behavior The posi tive externalities argument for strategic trade policy and its first cousin industrial policy have strong support in the literature Even though empirical evidence for the success of industrial policy is admit tedly mixed government support for particular industrial sectors has frequently been very successful in creating technologies that spill over into the rest of economy Most importantly there is strong evidence that government support for broadscale R D produces a very high payoff for the entire economy Certainly governments around the world believe that providing support for hightech industries is a highly productive investment over the long term Postwar Trade Regime The postWorld War II trading system was born in conflict between American and British negotiators at the Bretton Woods Conference 1944 Reflecting their industrial supremacy US negotiators wanted free trade and open foreign markets as soon as possible Although the British were also committed to the principle of free trade they were extremely concerned over the dollar shortage possible loss of do mestic economic autonomy to pursue a full employment policy and 217 C H A P T E R E I G H T a number of related issues The eventual compromise agreement to create the International Trade Organization ITO left many issues unresolved In 1948 the United States and its principal economic partners cre ated the General Agreement on Tarriffs and Trade GATT to pro mote freer and fairer trade primarily through negotiated reduc tions of formal tariffs When the ITO was turned down by the US Senate in 1950 the GATT became the worlds principal trade organi zation The GATT is a fixedrule trading system and such a rule based system is quite different from managed or resultsoriented trade that sets quantitative targets or outcomes The GATT was also based on the principle of multilateralism trade rules were extended without discrimination to all members of the GATT unilateralism bilateralism and trading blocs were prohibited except in unusual cases Another feature of the system was the principle of overall or general reciprocity that is trade liberalization and rules were to be determined by mutual balanced concessions A system of specific reci procity on the other hand requires that quite specific rather than general concessions must be made The GATT also incorporated pro visions for the impartial adjudication of disputes 31 Although the prin ciples of the GATT trade regime were significantly qualified by escape clauses and exceptions its creation was a major accomplishment and it has facilitated extremely important reductions in trade barriers The GATT proved remarkably successful in fostering trade liberal ization and providing a framework for trade discussions However in contrast to the abandoned ITO its authority and the scope of its responsibilities were severely limited it was essentially a negotiating forum rather than a true international organization and it had no rulemaking authority Moreover it lacked an adequate dispute settlement mechanism and its jurisdiction applied primarily to man ufactured goods The GATT did not have authority to deal with agriculture services intellectual property rights or foreign direct investment nor did the GATT have sufficient authority to deal with customs unions and other preferential trading arrangements Its power to resolve trade disputes was also highly circumscribed Suc cessive American Administrations and other governments became in creasingly cognizant of the GATTs inherent limitations and follow ing the Uruguay Round they incorporated it in 1995 within the World Trade Organization WTO whose responsibilities and au 31 Jagdish Bhagwati The World Trading System at Risk Princeton Princeton Uni versity Press 1991 218 T H E T R A D I N G S Y S T E M thority are much broader and which is a fullfledged international organization rather than merely an international secretariat like the GATT The GATT and later the WTO served the important political pur pose of facilitating the reduction of trade barriers The principle of comparative advantage indicates that a nation would increase its gains by opening its market to foreign goods also an open economy would enjoy lower prices consumer choice and greater national effi ciency Nevertheless because potential losers would strongly oppose lifting trade barriers proponents of free trade have to confront a mer cantilist attitude that believes exports are good and imports are bad This attitude is revealed when trade agreements are characterized as concessions to a foreign government Because of this prevalent atti tude and for other political reasons negotiated reductions of trade barriers based on the principle of reciprocity are necessary The politi cal logic of the GATTWTO is that because liberalization harms cer tain interests that will inevitably oppose trade liberalization it is nec essary to liberalize in a coordinated way with concession for concession thus making it easier to defeat protectionists Once trade barriers have been lowered a framework of agreements makes it quite difficult to raise them again The GATT despite the limitations of its mandate and its cumber some organizational structure was important for many years in re ducing barriers to international trade and in helping to establish rules to reduce trade conflict The GATT provided a rulebased regime of trade liberalization founded on the principles of nondiscrimination unconditional reciprocity and transparency for example use of for mal tariffs and publication of trade regulations as trade relations constitute a Prisoners Dilemma situation unambiguous rules are re quired to forestall conflict 32 Trade rules were determined and trade barriers were reduced through multilateral negotiations among GATT members In effect GATT members agreed to establish regula tions lowering trade barriers and then let markets determine trade patterns member states pledged not to resort to managed or results oriented trade that set import quotas for particular products Under GATT markets were opened and new rules established by interna tional negotiations agreements were based on compromise or uncon ditional reciprocity rather than on unilateral actions by the strong or by specific reciprocity GATTs goal was an open multilateralism that 32 Avinash K Dixit The Making of Economic Policy A TransactionCost Politics Perspective Cambridge MIT Press 1996 124 219 C H A P T E R E I G H T is the agreement provided for extension of negotiated trade rules to all members of the GATT without discrimination However candi dates for membership did have to meet certain criteria and agree to obey its rules The founders of the GATT wanted a steady progres sion toward an open world economy with no return to the cycle of retaliation and counterretaliation that had characterized the 1930s The postwar period witnessed a number of agreements to lower tariff barriers A significant shift in negotiations took place during the Kennedy Round 19641967 That Round initiated by the United States as a response to growing concern over the possible trade diver sion or discrimination consequences of the European Economic Com munity substituted general reciprocity for the prior productbyprod uct approach to tariff cuts specific reciprocity GATT members agreed to reduce tariffs on particular products by certain percentages and made tradeoffs across economic sectors The Round resulted in a reduction of trade barriers on manufactures of approximately 33 percent and in a number of basic reforms including regulation of dumping practices In addition preferential treatment was given to exports from less developed countries LDCs The next major initiative to liberalize trade was the Tokyo Round 19731979 which after years of bitter fighting proved far more comprehensive than earlier efforts It included significant tariff cuts on most industrial products liberalization of agricultural trade and reduction of nontariff barriers In addition the industrial countries pledged to pay greater attention to LDC demands for special treat ment of their exports However the most important task of the Tokyo Round was to fashion codes of conduct to deal with unfair trade practices To this end the negotiations prohibited export sub sidies and eliminated some discrimination in public procurement However that Round did not resolve the serious AmericanEuropean dispute over agriculture satisfy the LDCs or stop the noxious prolif eration of nontariff barriers that occurred as a consequence of the New Protectionism that had commenced in the 1970s 33 Nevertheless tradeliberalizing agreements did enable international trade to grow rapidly Substantial expansion of trade meant that im ports penetrated more deeply and trade became a much more impor tant component in domestic economies In fact in some European Economic Community countries exports soared And even the do mestic markets of the United States and Japan were internationalized 33 European Union agricultural subsidies are approximately 324 per acre in contrast to 34 per acre in the United States Burlington Free Press 12 December 1999 3A 220 T H E T R A D I N G S Y S T E M to a significant extent It is particularly noteworthy that Japanese im ports soon included a growing percentage of manufactured goods Meanwhile GATT membership greatly expanded over the years and growing trade flows created a highly interdependent international economy despite the 1970s slowdown The Uruguay Round and World Trade Organization By the mid1980s the Bretton Woods trade regime was no longer adequate to deal with a highly integrated world economy character ized by oligopolistic competition scale economies and dynamic com parative advantage In addition the New Protectionism of the 1970s had led to the erection of numerous nontariff barriers such as quotas and government subsidies 34 Moreover the character of trade itself was changing and outgrowing the rules and trading regime of the early postwar era Trade became closely intertwined with the global activities of multinational firms and trade in both services and manu factures expanded rapidly trade among industrialized countries be came the most prominent feature of the trading system In the 1980s the new regionalism especially acceleration of the movement to ward European integration was recognized as a threat to the multi lateral trading system And at least from the early 1980s the United States pressured its West European and other trading partners for a new round of trade negotiations to strengthen the multilateral trading system Eventually this American pressure overcame European and other resistance and the Uruguay Round of trade negotiations was launched at Punta del Este Uruguay in 1986 resulting in intense negotiations until its conclusion in 1993 The treaty produced by the Uruguay Round which came into force on January 1 1995 reduced tariffs on manufactured goods and low ered trade barriers in a number of important areas 35 At the same time 34 The New Protectionism as distinct from the old protectionism was character ized by hidden trade barriers a shift from rules to discretion and a return to bilateral ism See W M Corden The Revival of Protectionism New York Group of Thirty 1984 35 A detailed and optimistic assessment of the Uruguay Round is found in Ernest H Preeg Traders in a Brave New World The Uruguay Round and the Future of the International Trading System Chicago University of Chicago Press 1995 John Whalley and Colleen Hamilton on the other hand believe that the success of the Round was greatly overstated especially with respect to new rules governing anti dumping practices subsidies and other areas of agreement that were quite modest Nor they point out did it do much for services or FDI See Whalley and Hamilton The Trading System After the Uruguay Round Washington DC Institute for Inter national Economics 1996 221 C H A P T E R E I G H T that formal tariffs on merchandise goods were reduced to a very low level the Uruguay Round decreased or eliminated many import quo tas and subsidies The agreements twentynine separate accords also reduced trade barriers and for the first time extended trade rules to a number of areas that included agriculture textiles services intellec tual property rights and foreign investment By one estimate by the year 2002 the agreement should increase world welfare by approxi mately 270 billion While many economists and public officials praised the agreement others emphasized the modesty of its gains However the longterm effects of these achievements remain in doubt Speaking of the agreement John Jackson a leading expert on trade law stated that the devil is in the details 36 The Uruguay Rounds most significant accomplishment was the creation of the World Trade Organization WTO In doing this the Round took an important step toward completion of the framework of international institutions that had originally been proposed at Bret ton Woods 1944 Although the WTO incorporated the GATT along with many of its rules and practices the legal mandate and institu tional structure of the WTO were designed to enable it to play a much more important role than the GATT had played in governance of international commerce The WTO has more extensive and more binding rules Moreover the WTO has in effect the primary respon sibility to facilitate international economic cooperation in trade liber alization and to fill in the many details omitted in the 22000page Uruguay Treaty That Agreement establishing the WTO expanded and entrenched the GATT principle that trade should be governed by multilateral rules rather than by unilateral actions or bilateral negoti ations The World Trade Organization WTO is in essence an American creation The WTOs predecessor the General Agreement on Tariffs and Trade GATT had served well Americas fading massproduction economy but it did not serve the emerging economy equally well As a consequence of economic and technological developments prior to 36 The sheer magnitude of the agreement is extraordinary As John Jackson has com mented the Uruguay Round negotiations were undoubtedly the most extensive ever carried out by any international organization The agreement contained 22000 pages and weighed 385 pounds Although the agreement did not achieve many of the objec tives sought by the United States which had proposed the negotiations it was an impressive achievement nevertheless See John H Jackson in Peter B Kenen ed Man aging the World Economy Fifty Years After Bretton Woods Washington DC Insti tute for International Economics 1994 132f 222 T H E T R A D I N G S Y S T E M the Reagan Administration the United States had become an increas ingly serviceoriented and hightech economy Therefore in a major effort to reduce trade barriers the Uruguay Round was initiated by the Reagan Administration and later was supported by the Bush Ad ministration and after much vacillation by the Clinton Administra tion as well Although the WTO was not given as extensive rulemaking author ity as some desired it does have much more authority than the GATT The GATT disputesettlement mechanism was incorporated in the WTO reformed and greatly strengthened by elimination of such basic flaws as long delays in the proceedings of dispute panels the ability of disputants to block proceedings and the frequent failure of members to implement decisions The agreement also established a new appellate body to oversee the work of the dispute panels Most importantlyand controversiallythe WTO was empowered to levy fines on countries that refused to accept a decision of the dispute panel The institutional structure of the trade regime also changed signifi cantly Whereas the GATT had been a trade accord supported by a secretariat the WTO is a membership organization that increases the legal coherence among its wideranging rights and obligations and establishes a permanent forum for negotiations Biennial ministerial meetings should increase political guidance to the institution The Uruguay Round also created a tradepolicyreview mechanism to monitor member countries With over 130 members however the WTOs ability to carry out its assigned responsibilities is subject to doubt Despite the impressive achievements of the Uruguay Round in re ducing trade barriers many vexing issues were left unresolved Trade in certain areas such as agriculture textiles and shipping continues to be highly protected The failure to reduce tariffs on agriculture and textiles was and continues to be especially vexing because lower tar iffs would greatly benefit LDCs Trade barriers are still high in most developing countries especially with respect to services and devel oped countries continue to restrict imports of automobiles steel tex tiles consumer electronics and agricultural products Completion of the Uruguay Rounds socalled builtin agenda is crucial and the many issues unresolved at the close of the negotiations remain prob lematic at this writing In addition since the end of the Uruguay Round a number of new and extremely difficult issues have surfaced including labor standards the environment and human rights Even 223 C H A P T E R E I G H T more ominous American public opinion has become more skeptical of the costs and benefits of trade and by the late 1990s the WTO and trade liberalization were clearly on the defensive New Threats to an Open Trading System In order to deal with the many issues left unresolved in the Uruguay Round and eliminate the many barriers that continue to restrict free trade in 1999 the WTO prepared to launch a Millennium Round of trade negotiations The proposed round was very ambitious and the following issues were among the important matters to be considered 1 Further reduction of trade barriers on industrial products 2 Reductions of barriers particularly high tariffs in less developed countries to trade in services including information technology financial services and telecommunications 3 Reduction of fishing subsidies that promote overfishing 4 Simplification of customs procedures 5 Increasing transparency in government procurement of goods and services 6 Granting dutyfree access to ADC markets for the poorest coun tries 7 Extension of the interim agreement not to impose customs du ties on Internet transactions or ecommerce 8 Paving the way for agreement on foreign investment and compe tition policy 37 9 Reviewing WTO antidumping and antisubsidy rules to curb abuse of these otherwise legitimate trade rules 10 Reviewing problems in implementing existing builtin agree ments on textiles intellectual property protection and invest ment rules 11 Establishing a forum involving the World Trade Organization International Labor Organization and United Nations Confer ence on Trade and Development UNCTAD as well as other organizations to discuss links among trade economic develop ment and labor questions The Millennium Round where these important and highly contro versial trade issues were to be negotiated was to be launched in No vember 1999 at a WTO trade ministers meeting in Seattle Washing 37 The purpose of international competition policy or what Americans call anti trust policy is to set the terms on which global business is conducted 224 T H E T R A D I N G S Y S T E M ton Unfortunately strong differences among member governments especially among the three major economic powers along with tur moil in the streets resulted in near chaos and the collapse of that conference Launching of the Millenium Round therefore had to be delayed The New Trade Agenda As the volume of world trade expanded and trade penetrated more and more deeply into national societies it became increasingly en twined with politically sensitive matters and came into conflict with powerful domestic interests especially in the United States This de velopment has produced the new trade agenda which includes such highly controversial issues as labor standards human rights the environment and national sovereignty Although some proponents of the new trade agenda are unalterably opposed to free trade and are even outright protectionistsand large parts of American organized labor provide a prime example of those who want free trade only on their own parochial termsmost advocates of one or another of the issues on the new trade agenda want radical changes in the WTO that would most experts believe greatly weaken the trade regime Examination of the new trade agenda and the intense political contro versy surrounding various items reveals serious threats to the trade regime that will be difficult to overcome 38 The issues of fair labor standards human rights and environ mental protection center mainly on the question of whether these im portant and politically sensitive issues should be treated together with conventional trade issues or in a different venue On the one hand powerful groups especially in the United States and Western Europe believe strongly that these matters should be incorporated into the international trade regime and that trade liberalization should be made subordinate to achievement of the particular specific objectives of their varying political agendas On the other hand most econo mists governments and business groups are strongly opposed to in tegrating these issues into international trade negotiations fearing that however well intended some groups are the important issues of labor standards human rights and environmental protection will be and are being exploited by outright protectionists Indeed the stalemate generated by these possibly irreconcilable positions led to 38 These matters are discussed in I M Destler and Peter J Balint The New Politics of American Trade Trade Labor and the Environment Washington DC Institute for International Economics 1999 225 C H A P T E R E I G H T the defeat in 1997 of President Clintons request for fast track au thority that could have greatly facilitated negotiation of trade agree ments In the United States the opposition of environmentalists to the trade regime had become intense by the late 1990s 39 This opposition was inflamed by two controversial decisions of the trade dispute set tlement mechanism The first was a 1991 GATT ruling against the American ban on importing tuna caught by methods that killed dol phins the second was another trade ruling in 1998 against an Ameri can law intended to protect sea turtles The dolphin issue illustrates the difficulties created when environmental issues and trade matters intersect The case arose from a Mexican accusation that the Ameri can law protecting dolphins discriminated against Mexican fisher men The GATT based its ruling on the established principle that governments should not discriminate on the basis of the ways in which a good is produced This principle had been accepted because such an extension of GATT authority to cover productive processes would have required it to probe deeply into sensitive domestic mat ters and few countries would tolerate such an extension of authority In addition the American law had been poorly drafted and did indeed discriminate against Mexican fishermen Moreover the law had been passed without adequate discussions of the issue with Mexico A dif ferent approach might have met the desires of both environmentalists and those who feared that environmental laws would be used as pro tectionist devices American environmentalist critics of the trade regime fall into two major camps one of which accepts the principle of free trade but believes that environmental protection should be incorporated into trade negotiations and be given equal if not a higher priority than trade liberalization This group also believes that the WTO and its disputesettlement mechanism should become more open to the pub lic The other and more radical position opposes free trade as a threat to the environment and rejects the WTO as an instrument of powerful corporate interests this latter group agrees with American neoisola tionist conservatives that the WTO constitutes an infringement of American sovereignty Together the environmentalists have become a formidable force in the political struggle over trade Although few economists or other advocates of trade liberalization challenge the importance of protecting the environment most have 39 Daniel C Esty Greening the GATT Trade Environment and the Future Wash ington DC Institute for International Economics 1994 226 T H E T R A D I N G S Y S T E M strongly opposed integration of trade liberalization with environmen tal protection There is great concern that environmental regulations could and would be used to promote trade protection Many are also seriously concerned that trade measures designed to protect the envi ronment would shift the domain of trade negotiations from products to industrial processes Yet environmentalists are rightly concerned because trade negotiations and the trade regime do give priority to commercial interests over the environment and there is indeed reason to worry that trade negotiations could lead to a downward harmoni zation of environmental standards As both trade liberalization and environmental protection are desirable objectives work toward both goals must continue through international negotiations The issues initially raised by environmentalists in Seattle are serious and must be addressed by national governments Yet with a few par ticularly important exceptions such as global warming and pollution of the oceans almost every environmental issue can be most effec tively dealt with on a domestic or regional basis The serious prob lems of nuclear and other hazardous wastes water contamination air pollution toxic dumps and carbon dioxide CO2 emissions have lit tle or nothing to do with international trade One of the most vehe ment groups of protesters in Seattle consisted of opponents of logging and especially of clear cutting That problem is primarily the result of high government subsidies to timber companies as in Alaska and to forest destruction caused by landhungry farmers and the national development strategies in many less developed countries LDCs Even though the primary responsibility for overcutting belongs to na tional governments environmentalists have made the WTO the whip ping boy in this matter and many others Moreover even when envi ronmental issues do relate to international trade as does happen in ocean oil spills and in trade in endangered species the WTO does not have either the authority or the power to deal with such matters These pressing matters can be dealt with effectively in such other ways as international conventions this did happen in the interna tional agreement on safety rules for genetically modified foods 40 The issue of labor standards has become a major impediment to trade liberalization especially in the United States where it has been raised forcefully by organized labor and to a lesser extent by human rights advocates genuinely concerned over child labor in less devel oped countries and in China in particular Actually a disproportion 40 Although this agreement was hardly perfect it permits countries to bar imports of genetically modified foods New York Times 30 January 2000 A1 227 C H A P T E R E I G H T ate number of the street protesters in Seattle were union mem bers mobilized by the American AFLCIO whose president John Sweeney rejoiced at the collapse of the meeting The International Labor Organization ILO has established labor standards but most advocates of labor standards and opponents of child labor believe that that organization is much too ineffective to deal with these is sues moreover the United States and a number of other countries have not even ratified all of the ILOs standards Although some ad vocates of labor standards and of prohibitions against child labor are genuinely concerned over the oppressive conditions of labor in many countries others use the issue as a protectionist device Suspicion that American unions are more interested in keeping LDC exports out of the United States than they are in helping LDC workers is reinforced by the following episode in early 2000 the United States agreed to increase Cambodias quota of textiles imported into the United States in exchange for the latters agreement to improve labor standards including raising wages substantially Under the agreement Cambo dian textile workers would have earned 40 per month compared to 20 per month for Cambodian university professors However implementation of this agreement was blocked by American unions 41 Most economists businesses and national governments also reject the idea that labor standards and human rights should be incorpo rated into trade negotiations Economists are concerned that consid eration of labor standards in trade negotiations would unduly compli cate the already horrendous task of achieving agreement on trade liberalization and would provide a convenient and effective rationale for protectionist measures against lowwage economies Developing countries have strongly denounced efforts to impose Western stan dards on them They have reason to believe that such proposals are motivated by protectionist interests and would be used to reduce their comparative advantage based on lowwage labor and provision of only minimum welfare benefits The closely related issues of labor standards human rights and child labor are legitimate and need to be addressed Furthermore some countries are undoubtedly guilty of social dumping that is of competing through denying workers fundamental rights and decent working conditions However remedying the problem will be ex traordinarily difficult As almost every LDC is strongly opposed to incorporating labor standards and human rights into the WTO the effort to do so would be likely to destroy the effectiveness of the 41 Wall Street Journal 28 February 2000 A1 228 T H E T R A D I N G S Y S T E M organization It is particularly ironic that many of the protestors at Seattle who denounced the rulings of the WTO as an infringement of American sovereignty also advocated that the WTO impose labor and human rights standards on delinquent LDCs Needless to say it will be difficult indeed to reconcile the positions of those who desire and those who oppose incorporation of workers rights into the trade re gime Ultimately the solution to the associated problems of labor stan dards human rights and child labor must be provided through a combination of education and economic development In general those countries with the highest labor and environmental standards and those that have respect for human rights are the most developed countries countries in which there is great wealth and a strong and concerned middle class In societies with low income per capita where parents frequently need the wages of their children outside intervention like trade sanctions is unlikely to succeed 42 In the short term the best solution is to exert organized consumer pressure against those firms and countries that violate decent labor standards human rights and child labor For example according to the New York Timess Thomas Friedman following the GATT ruling against the American law banning tuna caught with nets that also catch dol phins consumer pressures in the United States forced firms and the fishermen they deal with to change their practices soon many brands carried the label dolphin safe 43 While such a method of dealing with a problem would fail to satisfy the AFLCIO and others there is some evidence that suggests that this technique has been used suc cessfully with certain issues One of the most disturbing aspects of the new trade agenda is that the WTO and other international economic institutions have come under heated attack by an unholy alliance of environmentalists and human rights advocates protectionist trade unions and ultraconser vative neoisolationists As in the vehement protests surrounding the WTOs November 1999 meeting in Seattle and the April 2000 pro tests in Washington the WTO and other international agencies have become lightning rods for concerned and frustrated groups around the globe who want the world to be different from its present unfor tunate state The impossible and contradictory demands of the Seattle protesters ranged from abolishing the WTO altogether because it is 42 Economists such as Jeffrey Sachs and Paul R Krugman have pointed out that the important issue in many LDCs is whether there will be enough jobs 43 Thomas Friedman New York Times 8 December 1999 A31 229 C H A P T E R E I G H T undemocratic and infringes on American sovereignty to demands that it actively intervene in the sovereign affairs of nations to elimi nate such destructive practices as forest clearcutting and pollution of streams lakes and rivers The World Trade Organization the World Bank and the International Monetary Fund have become the symbols of globalization for all those groups and individuals who blame glob alization for their own and the worlds problems International economic institutions have certainly made a number of serious mistakes The controversial role of the IMF in the East Asian financial crisis is a prime example The World Bank also has funded many questionable projects in poor countries The WTO may have erred in certain of its decisions Reforms that will make these institutions more accountable and sensitive to noneconomic matters are required Yet the wholesale attack on these institutions by the political left and right is unwarranted It is wrong for example to blame these institutions for failures to achieve debt relief for poor countries to open ADC markets to LDC exports and to prevent the environmental damage caused by development projects supported by the World Bank The responsibility for these failures lies with na tional governments Debt relief was thwarted by the refusal of the rich industrial nations to appropriate the funds required to make debt relief possible Opening the American market to more LDC goods has been resisted by labor unions and other powerful interests Pre vention of the environmental damage caused by large development projects in less developed countries has seldom been a priority for the LDCs themselves If these and other problems of the global economy are to be resolved protesters should direct their attention to the na tional governments that are ultimately responsible The argument that the WTO violates American sovereignty and somehow has been imposed on the United States is particularly dis turbing The WTO was created by a treaty sponsored by President Reagan has been endorsed by Presidents Bush and Clinton and was ratified by a twothirds vote of the United States Senate Under the American Constitution a ratified international treaty becomes part of the law of the land and is incorporated into the definition of Ameri can sovereignty The United States and other members have delegated to the WTO the responsibility to enforce existing trade agreements It is not as critics charge a supergovernment that can legislate new laws A dispute panels interpretation of a trade law obviously can have a significant effect on trade regulations but the WTO cannot force a country to do anything against its will Moreover interna 230 T H E T R A D I N G S Y S T E M tional law permits a nation to abrogate a treaty if it believes that the treaty no longer serves its national interest Disarray Among Major Economic Powers Although the Seattle street protestors attracted the most attention at the November 1999 WTO meeting responsibility for the abysmal failure of that meeting belongs to the major economic powers and to the Clinton Administration in particular For domestic political rea sons President Clinton tried to force the conference to include the issue of labor standards on the agenda of future trade negotiations His irresponsible reference in a newspaper interview to the imposition of economic sanctions on countries that did not meet certain labor standards was especially noxious to developing countries who quite correctly viewed the Presidents motives as protectionist Another fac tor in the breakdown of the negotiations was the inexperience of the newly appointed WTO DirectorGeneral Mike Moore Still other fac tors were the lack of adequate preparation for the meeting lack of an agreedupon agenda the unwieldiness of a meeting composed of 135 membernations and the brusque chairmanship of Charlene Barshefsky head of the US delegation 44 The unwillingness of the major economic powers especially the United States and the European Union EU to contemplate serious trade liberalization was also critical in the Seattle fiasco Each major economic power had a different agenda that conflicted with others and precluded a successful outcome High on the Clinton Administra tions formal agenda were such issues as elimination of European ag ricultural subsidies and protection of intellectual property rights However at the conference President Clinton subordinated this for mal agenda to the issue of labor standards Furthermore the Clinton Administration refused to discuss the outrage in Japan and other countries over the Administrations extensive and improper use of the WTOs antidumping provision as a protectionist device 45 The Ad ministration also opposed the European Unions EUs strong desire to put competition policy on the agenda and instead supported a nar 44 Ms Barshefsky insisted on chairing the meeting with what many delegates charged was an abrasive and domineering style Poorer members for example complained that they were excluded from behind closed doors meetings where important decisions were made 45 Under both GATT and WTO rules a country can impose duties on goods being dumped on the world market Both the United States and Western Europe have grossly misused this safeguard provision for purely protectionist purposes 231 C H A P T E R E I G H T row agenda favoring American export interestsfinancial services information technology aircraft and agriculturewhile demonstrat ing little concern for the welfare of American consumers At Seattle both the Japanese and the West Europeans also for domestic political reasons adamantly opposed opening their econo mies to agricultural imports In the EU protection of agriculture through large subsidies to farmers is considered essential to the achievement of European economic and political integration In Ja pan the ruling Liberal Democratic Party needing the votes of rural Japanese opposed opening its market to imports of rice and other agricultural imports The inability of the major economic powers to find compromises to these fundamental differences doomed the con ference to failure For all three major participants domestic political objectives took precedence over trade liberalization The prospects for a major breakthrough in trade negotiations are not especially promising Trade barriers in a number of important sectors such as textiles and agriculture may have declined but only to a level that is politically acceptable to powerful constituencies Moreover both in the United States and in Western Europe public opinion has grown increasingly worried about the impact of imports especially from lowwage economies In addition to obstacles to fur ther liberalization raised by the industrialized countries the industri alizing countries have also become increasingly disillusioned with opening their markets Experience of the East Asian economic crisis has increased the concerns of many about the dangers of opening their economies 46 Reenergizing the process of trade liberalization will require strong political leadership Conclusion The trade regime was one of the most important achievements of the latter half of the twentieth century The eight GATT rounds of trade negotiations beginning with the Kennedy Round in the early 1960s reduced tariffs in industrialized countries to less than 4 percent on average onetenth of what they had been in the 1940s quotas were reduced and many subsidies were reduced or eliminated There are estimates that lowered trade barriers have put an additional 1000 annually into the pockets of American consumers The economies of less developed countries have also gained greatly as these countries 46 David Woods The Seattle Fiasco Braudel Papers No 24 Sao Paulo Brazil Braudel Institute 2000 1 232 T H E T R A D I N G S Y S T E M have reduced their own trade barriers Despite intense controversy over some of its decisions the WTO dispute mechanism thus far has worked well The number of GATTWTO members has increased from twentythree to one hundred thirtyfive and about thirty addi tional states wish to join in 2000 The shift around the world since the 1980s to more marketoriented economic policies is indicated by all these developments However as trade has expanded and pene trated more deeply into domestic economies and the trade agenda has broadened significantly trade has come into conflict with powerful local interests and has thus become increasingly controversial The clash between the forces of economic globalization and domestic con cerns has triggered a backlash against globalization that threatens to undermine the political foundations of the trade regime 233 CHAPTER NINE The International Monetary System I N THE DECADES immediately following World War II monetary and financial affairs were in general isolated from one another 1 The international monetary system based on fixed but adjustable ex change rates was generally isolated from international finance with little interaction between the two In fact there was really no interna tional financial system as we now conceive it because almost every country maintained capital controls This relatively simple situation began to unravel in the 1960s with the emergence of the Eurodollar market 2 The first oil crisis in 1973 and the subsequent huge financial surplus of the Organization of Petroleum Exporting Countries OPEC changed this situation and led to creation of an international financial system This then led to the integration of international money and international finance For the first time in the postwar era the international monetary system and international finance inter acted and influenced one another Whereas the purpose of the international monetary system is to facilitate transactions in what economists call the real economy trade manufacturing etc the purpose of the financial system is to provide the investment capital required for economic activities and development around the globe Both the efficiency and the wellbeing of the world economy are profoundly affected by the success or fail ure of one or another of the two systems However the close ties of the international monetary system and international finance in the contemporary era have made the tasks of both systems much more difficult As flows of international capital and foreign investment are conducted in money changes in exchange ratesthat is in the value of particular currenciesinevitably change the value of an invest ment If one buys dollars to invest in the United States and the value 1 This chapter draws from Robert Gilpin The Challenge of Global Capitalism Princeton Princeton University Press 2000 Chapter 4 2 The Eurodollar market consists of foreign currencies especially dollars on deposit in West European and other international banks The origins of the Eurodollar market lay principally in the desire of American banks to escape Regulation Q which set an upper limit on interest charges An additional factor in the rise of the Eurodollar mar ket was hard currency deposits of the Soviet Union in European banks 234 T H E I N T E R N A T I O N A L M O N E T A R Y S Y S T E M of the dollar falls then the value of the investment is that much less Similarly international flows of foreign capital can cause a currency to appreciate rise in value as happened to the dollar in the early 1980s and during much of the 1990s Erratic exchange rates can dis courage trade and foreign investment and international financial flows in turn can cause erratic exchange rates Both the international monetary system and the international financial system are vulnera ble and disturbances in either or both systems can cause international economic turmoil like that in East Asia during the late 1990s Although the monetary and financial aspects of the world economy are intimately linked one can separate them for analytic purposes This chapter concentrates on the international monetary system and the following chapter on international finance There has been no stable and satisfactory international monetary system since the break down of the system of fixed exchange rates in the early 1970s Re form of the monetary system involves complex technical issues and every possible solution to technical matters carries important implica tions for the distribution of wealth both among and within national economies and for the welfare of individual states Prospects for a stable and integrated international monetary system will remain clouded until and unless these difficult technical and political matters can be resolved The Postwar International Monetary System The postWorld War II international monetary system was designed in 1944 and its fundamental principle was that exchange rates should be fixed in order to avoid the beggarthyneighbor policies of the 1930s and the ensuing economic anarchy The International Mone tary Fund IMF created at that time was intended to achieve this goal and to provide monetary reserves sufficient to enable member governments to maintain the exchange rates for their currencies at predetermined values The IMF was designed to use contributions from member countries and to offer reserve credits to states with in ternational payments problems In addition the monetary system had to anchor its members monetary policies to some objective standard in order to prevent global inflation or devaluation Stabilization of a monetary system can be achieved by tying every currency to a non monetary asset gold being the asset of choice by coordinating na tional monetary policies or by following a leader whose past policies promise that it will provide the desired degree of economic stability in the future Although all three methods were in fact employed in 235 C H A P T E R N I N E the early postwar years the monetary policies of member states were anchored by tying every currency to the dollar which in turn was tied to gold the major powers also informally coordinated their economic policies The postwar monetary system of fixed rates which lasted until the early 1970s proved extraordinarily successful Designed to provide both domestic policy autonomy and international monetary stability the system in effect provided a compromise between the rigid gold standard of the late nineteenth century under which governments had very little ability to manage their own economies and the mone tary anarchy of the 1930s when governments had too much license to engage in competitive devaluations and other destructive practices To achieve both autonomy and stability the system was based on the following principles fixed or pegged exchange rates along with sufficient flexibility to enable individual states to deal with extraordi nary situations including pursuit of full employment reliable reserve credit in the event of an international payments problem and agree ment among member countries to peg their currencies to the dollar at 35 an ounce in gold The International Monetary Fund was re sponsible for managing the system through approval of exchange rate adjustment in the event of a fundamental disequilibrium in a nations balance of payments the IMF could also make its monetary reserves available to deficit countries These principles governed the system quite successfully for nearly three decades The ways in which the system actually functioned however did not fulfill the intentions and expectations of its founders A significant difference was that although the IMF had been assigned responsibil ity for maintaining reserves in practice the buildup in dollar reserves held by member governments actually achieved this goal and the American dollar became the foundation of the international monetary system in this way Cooperation among the United States and its al lies and the passive US attitude toward the dollars exchange rate before 1971 made IMF actions in this area unnecessary In the early postwar era members also followed US policy preferences and they were reassured that this would provide stability to the system How ever by the time of the Vietnam War in the 1960s the United States had ceased to pursue price stability and inflation acceleration caused by that war eventually led the Nixon Administration to abandon the fixedrate system in August 1971 Yet even then the United States and the dollar remained central to the system The key role of the dollar in the international monetary system facilitated the American alliance system and functioning of the world 236 T H E I N T E R N A T I O N A L M O N E T A R Y S Y S T E M economy the international role of the dollar as both a reserve and a transaction currency became a cornerstone of Americas global eco nomic and political position Because for political as well as for eco nomic reasons Americas major allies and economic partners were willing to hold dollars the international role of the dollar conferred on the United States the right of seigniorage this means that the provider of the currency for an economy in this case the international economy enjoys certain privileges As President Charles de DeGaulle of France bitterly complained in the 1960s the hegemony of the dollar conferred extravagant privileges on the United States be cause it alone could simply print dollars to fight foreign wars could buy up French and other businesses and could go deeply into debt without fearing negative consequences Nevertheless there was a fundamental contradiction at the heart of this dollarbased system While the huge outflow of American dol lars to finance the rebuilding of Western Europe and Japan and the American military buildup during both the Korean and Vietnam Wars helped solve certain problems this outflow of dollars meant that the United States would one day be unable to redeem in gold and at the agreed price of 35 per ounce those dollars held by private investors and foreign governments Robert Triffin in a series of writ ings predicted that confidence in the dollar would be undermined as the American balance of payments shifted from a surplus to a deficit 3 This problem did become acute late in the 1960s when escalation of the Vietnam War and its inflationary consequences caused deteriora tion in international confidence in the value of the dollar As that confidence declined the foundations of the Bretton Woods System of fixed rates began to erode Decreased confidence in the dollar also led to intensifying specula tion in gold and this was followed by futile attempts to find ways to recreate confidence in the system For example in the late 1960s Special Drawing Rights SDRs were created by the IMF as a new reserve asset although they were never utilized extensively However as Benjamin Cohen has convincingly argued it was only when a polit ical solution was devised that maintenance of the dominant position of the dollar was ensured 4 Americas Cold War allies fearing that collapse of the dollar would force the United States to withdraw its forces from overseas and to retreat into political isolation agreed to 3 Robert Triffin Gold and the Dollar Crisis The Future of Convertibility New Ha ven Yale University Press 1960 4 Benjamin J Cohen Organizing the Worlds Money The Political Economy of In ternational Monetary Relations New York Basic Books 1977 237 C H A P T E R N I N E continue to hold overvalued dollars The dollar was also bolstered for a period of time because such exportoriented economies as West Germany and at a later date Japan wanted to retain access to the lucrative American market and therefore supported the high dollar However as soaring inflation undercut the value of the dollar a more fundamental economic solution was needed The End of Fixed Exchange Rates In the early 1970s the deteriorating position of the dollar became the central issue in the world economy Escalation of the Vietnam War and the simultaneous launching of the Great Society Program by the Johnson Administration 19631969 had caused the global rate of inflation to accelerate and to threaten the value of the dollar The US government attempting to hide the financial cost of the Vietnam War from the American people refused to increase taxes and chose instead to pay for its warfare and welfare policies through inflation ary macroeconomic policies The succeeding Nixon Administration 19691974 compounded the problem of inflation In addition the Federal Reserve threw caution to the wind as it stimulated the econ omy a move that critics labeled a blatant attempt to reelect Nixon Subsequent intensification of speculative attacks on the overvalued dollar and ballooning of the American tradepayments deficit resulted in the Nixon Administrations decision on August 15 1971 to force devaluation of the dollar To achieve the goal of a devalued dollar and to overcome the oppo sition of foreign export interests the United States announced that it would no longer redeem dollars for gold Simultaneously to force other countries to appreciate their currencies the Administration im posed a 10 percent surcharge on imports into the American economy and announced that the surcharge would be removed only after a satisfactory devaluation of the dollar had been achieved Following bitter denunciations of this unilateral American action especially by West Europeans and after intense negotiations the dollar was indeed substantially devalued by the Smithsonian Agreement of December 1971 in which other countries agreed to appreciate their currencies The international monetary system was thus changed at least de facto from one based on fixed exchange rates to one based on flexible rates In this way the postwar system of fixed exchange rates had become a casualty of reckless American policies high inflation and increasing international mobility of capital 238 T H E I N T E R N A T I O N A L M O N E T A R Y S Y S T E M Subsequent efforts of an international committee to develop a new system of stable exchange rates failed The overwhelming problems posed by increased capital mobility along with fundamental differ ences between the United States and Western Europe over any new system made agreement impossible As a consequence of this im passe the major industrial powers accepted economic reality at the Jamaica Conference 1976 and instituted flexible rates I describe this situation as a nonsystem because there were no generally recog nized rules to guide the flexible rates or any other decisions on inter national monetary affairs The Financial Revolution and Monetary Affairs The shift from a system of fixed to flexible exchange rates generated an intense debate in the economics profession The majority of econo mists certainly at least the majority of American economists ex pected that this shift would be beneficial for the world economy They believed that the combination of fixed rates and increasing economic interdependence through trade investment and monetary flows had imposed severe constraints on national economic policy and thereby had decreased the ability of individual governments to pursue macro economic policies that would promote full employment and other economic benefits Economists believed that a system of flexible rates would delink national economies from one another and thus permit every government to pursue those economic policies best suited to its own national circumstances A minority of economists however strongly disagreed with this optimistic assessment and was very concerned about the potentially inflationary and destabilizing consequences of delinking the interna tional monetary system from the anchor of gold or some other com modity If the system were not anchored to an objective standard the value of money and the stability of prices they reasoned would henceforth rest entirely on the discretion of individual governments Believing that governments were not to be trusted to pursue stable economic policies they worried that governments would behave so irresponsibly that inflation and monetary instability would soon dis rupt the world economy The majority of economists remained convinced that their col leagues fears of inflation and instability were unfounded However the unanticipated financial revolution of the mid1970s and its consequences proved that the optimism of the majority of economists had been unfounded Growth of the Eurodollar market and overseas 239 C H A P T E R N I N E expansion of American banks in the 1960s had resulted in the emer gence of an international financial market Then in the 1970s devel opment of the new international financial system accelerated follow ing deregulation of domestic financial systems removal of capital controls in a number of countries and the greatly increased size and velocity of global financial flows an increase made possible by mod ern communications and new financial techniques and instruments Moreover the huge OPEC monetary surplus following the first oil crisis and the need to recycle those funds proved important in the development of the international financial market Before the end of the 1970s the scale and velocity of international financial flows had expanded enormously and had truly transformed the international economic system Integration of global financial markets and increased monetary and financial interdependence of national economies had a significant im pact on domestic as well as international economics Financial market integration means that the macroeconomic policies of one country have a significant impact on the economic welfare of other countries For example if country A raises its interest rates to decrease domestic inflationary pressures those higher rates will attract capital from other countries with lower interest rates and the resulting increase in country As money supply then contributes to the inflationary pres sures that higher interest rates were intended to counter Simultane ously economic activity is reduced in the economies from which the capital flows Integration of national financial markets actually re duced macroeconomic policy autonomy Despite the shift to flexible exchange rates domestic and international economic spheres became even more closely linked to one another because of financial market integration Another unanticipated consequence of the financial revolution has been that international financial flows have become an important de terminant of exchange rates at least in the short term This situation has greatly increased exchange rate volatility especially between the dollar and other major currencies the Japanese yen and the German mark By the end of the 1970s international financial flows dwarfed trade flows by a ratio of about 251 the size of the flows also contrib uted greatly to volatility The tendency of exchange rates to over shoot in response to financial flows has proved important in produc ing fluctuations that is the exchange rate tends to make large swings up and down rather than find a new and stable equilibrium and such overshooting causes a disequilibrium in currency values and hence increases exchange rate volatility This situation has made it difficult 240 T H E I N T E R N A T I O N A L M O N E T A R Y S Y S T E M for markets to move smoothly from one equilibrium exchange rate to the next and for anyone to know what the equilibrium exchange rate should be Since fixed rates were eliminated economists and public officials have debated heatedly whether or not exchange rate volatility has produced negative consequences for the real economy through its im pact on trade flows business activity and economic growth Some economists believe that volatile rates may have contributed to devel opment of the New Protectionism in the mid1970s Many econo mists now believe that the world should return to a system of fixed rates because of the high costs of exchange rate volatility Freeing financial markets facilitated reorganization and transfor mation of international business Increased integration of national fi nancial markets encouraged creation of a single globally integrated market for corporation ownership and such corporate takeover activ ities as the late1990s merger of Chrysler and DaimlerBenz Al though in Japan government regulations and the system of corporate groupings or keiretsu have made foreign takeovers very difficult else where there has been a huge increase in acquisitions and alliances by multinational corporations since the mid1970s The substantial increase in international interdependence has also had a profound impact on domestic economic policy Economic inter dependence considerably reduced the capacity of many countries to pursue fullemployment policies and this in turn undermined the do mestic consensus supporting an open world economy Increased inter dependence also has integrated such onceisolated policy issues as trade flows and exchange rate determination thus immensely compli cating the task of managing the world economy and raising important questions about the adequacy of the rules governing international economic affairs With these several developments the Bretton Woods rulebased in ternational monetary system was replaced by a shaky political agree ment among the dominant economic powers G7 this change made the central bankers of the major economic powers de facto managers of the international monetary system What soon became known as the reference range system was based on the cooperative and sometimes not so cooperative efforts of central bankers and finance ministers to stabilize currency values As time went by however this cooperative mechanism became less and less satisfactory and many proposals have been put forth to reform the nonsystem and to return to a rulebased system or at least to a more satisfactory arrangement based on cooperation among the major economic powers Lacking a 241 C H A P T E R N I N E satisfactory solution to the problem of unstable exchange rates and frustrated by what they considered to be irresponsible American mac roeconomic policies West Europeans sought to isolate themselves from American actions through creation of the European Monetary System EMS and the accompanying Exchange Rate Mechanism ERM This European initiative became a further important step in the development of regional arrangements within the international monetary system Despite these setbacks efforts to strengthen inter national monetary affairs have continued Embedded Technical and Political Issues Although an efficient international monetary system benefits every country serious political and economic difficulties almost invariably impede creation or reform of an international monetary system Every solution to technical problems has important distributive conse quences that affect differently both various nations and powerful do mestic constituencies strong reactions can be evoked because some may lose more or benefit less than others from any new monetary arrangement During the early postwar years both the United States and its trading partners were upset over the asymmetries of the dol larbased system Many Europeans objected to the economic and po litical privileges bestowed on the United States and the United States as the reservecurrency country fretted increasingly over its inability to reduce its trade deficit by devaluing the dollar Eventually Presi dent Nixon in August 1971 solved American concerns about asym metry by forcing appreciation of other currencies The creation andor reform of an international monetary system involves highly complex technical issues The formal models and mathematical techniques of economists that are required to deal with monetary and financial matters are beyond the technical competence of most noneconomists and even beyond many economists yet the international monetary system is of intense concern and importance to national governments and private economic interests The mecha nisms responsible for the systems efficient functioningadjustment liquidity creation and confidencebuilding measuresproduce a dif ferential impact on the national interests of various countries and also on the interests of powerful groups within economies Technical mechanisms are seldom politically neutral they affect the economic welfare political autonomy and even the international prestige of individual states and they also have an impact on the interests of capital labor and other domestic groups Every state wants an effi 242 T H E I N T E R N A T I O N A L M O N E T A R Y S Y S T E M cient and wellfunctioning international monetary system However individual states and powerful domestic groups may disagree strongly on specific matters such as currency values and the precise mecha nisms employed to solve technical problems The distributive consequences of solutions to technical problems are illustrated by the liquidity issue which is closely tied to the issue of seigniorage that is the economic benefits accruing to the country whose currency is used as the basis of the international monetary system Solutions to the adjustment problem determine whether defi cit or surplus countries must pay the high costs of reestablishing a balanceofpayments equilibrium The nature of the international monetary system also has important implications for such different constituencies as tradeablenontradeable sectors labor andor capital and industryfinance Political differences mean that a wellfunctioning monetary system requires strong leadership by a nation or group of nations with an interest in maintaining the system The leaders must assume the ini tiative in solving highly technical problems as well as providing and managing the key currency used for maintaining reserves carrying out economic transactions and providing liquidity Furthermore the leader should be the lender of last resort and from time to time should provide financial assistance to countries experiencing severe financial problems Although this leadership role could in theory be provided by two or more nations or even by an international organi zation leadership has historically been provided by a dominant eco nomic and military power for example Great Britain in the late nine teenth century and the United States following World War II Not surprisingly the rules governing the international monetary system have in general reflected the interests of the leading economic powers The Belgian economist Paul DeGrauwe has pointed out that econ omists differ fundamentally with one another over almost every as pect of international monetary affairs from determination of cur rency values to the virtues of fixed versus floating rates this makes explication of economists views on this matter quite challenging 5 Particularly since the early 1970s the area of international monetary affairs has been the focus of intense controversy Although profes sional books and journals have been filled with proposals to reform the regime few proposals have been implemented and the monetary systems inherent problems and contradictions remain unresolved 5 Paul DeGrauwe International Money PostWar Trends and Theories Oxford Clarendon Press 1989 243 C H A P T E R N I N E Economists theories about the varied and complex aspects of the in ternational monetary regime have usually followed rather than pre ceded events that they attempt to explain Indeed many theories re garding monetary affairs have been merely expostfacto explanations of important developments that economists had failed to predict Such theoretical and policy differences among experts increase the difficulties of finding solutions to the problems Adjustment An international monetary regime must determine the method by which national economies will restore equilibrium ie reduce a deficit or a surplus in their international accounts balance of pay ments and an efficient international monetary system should mini mize the costs of making adjustments Every adjustment policy results in economic costs and some methods of adjustment are considerably more costly for individual economies and for the overall world econ omy than are others A country with an imbalance in its international payments may pursue such shortterm expedients as drawing down its national re serves a deficit country or adding to its national reserves a surplus country However with few exceptions a deficit country cannot continue drawing down its reserves for very long and eventually the debtor country must take measures to eliminate the cause of the im balance On the other hand a surplus country like the United States for much of the twentieth century and Japan at the end of the century can continue to add to its reserves for a very long time a practice that irritates its trading partners Both deficit and surplus countries employ additional methods to overcome payments imbalances One such method is to change the exchange rate by devaluing the currency a deficit country or appreciating it a surplus country Another method is to make changes in macroeconomic policy that is to shift to deflationary a deficit country or expansionary a surplus country economic policies Some currencies will inevitably get out of line with one another Many nations live beyond their means and pursue inflationary poli cies others like Japan during most of the second half of the twentieth century desire a continuous payments surplus and therefore choose to live below their means a deflationary policy Such national differ ences in inflationdeflation rates will cause currency values to change some method acceptable to all must be available to bring currencies back into equilibrium And of course for every deficit country there must be surplus elsewhere While either the deficit or surplus country 244 T H E I N T E R N A T I O N A L M O N E T A R Y S Y S T E M or both could make adjustments under the Bretton Woods System it was generally assumed that the burden of adjustment rested with the deficit country However the deficit country can and frequently does take actions to impose the costs of adjustment on the surplus country For example the United States has attempted with some modest success to impose the burden of adjustment on Japan through policies intended to eliminate the AmericanJapanese tradepayments imbalance Adjustment for a deficit country means that it must reduce its standard of living or at least reduce the rate of increase in that stan dard achieve a longterm reduction in national income andor reduce employment levels The rules governing the international monetary system will determine the approved methods of making such an ad justment However regardless of the choices available transition from high living to living within ones means must necessarily impose a real cost on the deficit country and the precise manner in which adjustment occurs will also impose costs on other countries For example the deflationary consequences of the East Asian finan cial crisis harmed many American exporters It is clear that all coun tries would like to shift as many adjustment costs as possible to others and away from themselves Working out the distribution of the costs of adjustment among deficit and surplus nations is at the heart of solving the adjustment problem For a deficit country living beyond its means both currency devalu ation andor deflation of the economy are painful because the former entails a drop in national income and the latter a rise in unemploy ment For a surplus country currency appreciation is painful for its export industries but beneficial for its importers and consumers on the other hand macroeconomic stimulus of the economy carries the risk of inflation How much better it would be therefore to transfer the adjustment costs to ones trading partners As mentioned above a case in point is the longsimmering economic clash between the deficit United States and the surplus Japan From the 1980s onward the United States resisted deflationary policies that would reduce its trade deficit but would also mean a decline in the American standard of living Meanwhile Japan resisted an appreciation of the yen that would harm its export industries and Japanese agreement at the Plaza Conference September 22 1985 to appreciate the yen was achieved only after intense American pressures Since solution of the adjustment problem impinges on the interests of states and of power ful interests within states adjustment mechanisms do and will reflect the interests of powerful states and groups 245 C H A P T E R N I N E Liquidity An efficient international monetary system must also provide interna tional liquidity Participating countries must have financial reserves sufficient to meet balanceofpayments deficits caused by such eco nomic shocks to the system as the sudden increase in the price of petroleum in 1973 or by persistent use of such unwise policies as an inflationary macroeconomic policy or maintenance of an overvalued currency Reserves are important because they enable a deficit coun try to finance at least for a short period a payments disequilibrium and to increase the time and options available to the country as it seeks a longerterm solution to its deficit problem A country can also use reserves to delay a possibly costly devaluation of its currency A nations reserves like any other form of money are also a store of value they may include gold convertible foreign currencies or depos its with the International Monetary Fund While provision of optimal international liquidity facilitates the world economys functioning neither underprovision nor overprovi sion is desirable Underprovision may be recessionary and overprovi sion inflationary Under the gold standard during the last decades of the nineteenth century there was underprovision of reserves and while the gold standard was a very stable system this system fre quently resulted in high levels of unemployment and depressed wages On the other hand during the early postWorld War II era of the dollar standard overprovision of reserves by the United States meant a high level of inflation that eventually led to the breakdown of the Bretton Woods monetary system of fixed rates With economists and governments disagreeing about the rules that should govern interna tional reserves the rule of the strong has generally prevailed and the dominant powers have had a significant impact at least over the shortterm on maintaining the level of international liquidity to ac cord with their own economic and political interests Seigniorage is an important aspect of liquidity creation Not only is national prestige enhanced when a nations currency is selected as the most important currency but seigniorage can also be a major source of increased income to the nation particularly to its banking system In addition seigniorage can increase the economic and politi cal autonomy of the country because that country is freed at least for a time from balanceofpayments constraints On the other hand seigniorage has associated costs for example the nation with the right of seigniorage usually has to pay interest to other countries holding assets denominated in its currency To maintain seigniorage 246 T H E I N T E R N A T I O N A L M O N E T A R Y S Y S T E M also means that a country must avoid actions that undermine confi dence in the value of its currency Moreover the country supplying the key currency may find it difficult to devalue its currency as hap pened to the United States in the early 1970s Increased national income and national autonomy or freedom of action are important benefits of seigniorage The banking system of a country supplying an international currency enjoys both economies of scale and other cost advantages over its competitors simply because most international reserves and transactions are held in its national currency Under the gold standard in the late nineteenth century Brit ish sterling was the key currency and London financial institutions enjoyed high profits as the center of the international monetary sys tem Following World War I London and sterling were challenged by New York and the dollar and the profits from seigniorage began to flow to the United States and its banking system It remains to be seen whether or not the euro of the European Union and a European city or cities will appropriate financial and monetary leadership in the twentyfirst century Seigniorage also confers greater freedom from economic restraints on the keycurrency country and hence more autonomy than other countries enjoy Throughout the Cold War the capacity of the United States to fight foreign wars maintain troops abroad and finance its foreign policy was largely dependent on the willingness of its allies to hold American dollars and dollardenominated assets Even after the Cold War the role of the dollar as the worlds key currency permitted the United States to live far beyond its means for years and thus to become the worlds foremost debtor nation Other countries by hold ing dollars actually gave the United States interestfree loans As the American debt has been denominated in dollars this debt burden could be inflated away and devaluation of the dollar in the 1990s did indeed reduce the debt owed by the United States while simultane ously imposing heavy costs on Japanese and other lenders Neverthe less the United States will continue to enjoy the privileges of seignior age as long as there is no acceptable alternative and holders of dollars or dollardenominated assets maintain confidence in the dollar Confidence A stable international monetary system is also dependent on solution of the confidence credibility problem other countries must have confidence that the reservecurrency country will not pursue infla tionary policies leading to devaluation of their own reserves If they lose confidence other countries will shift the composition of their 247 C H A P T E R N I N E reserves A shift can also occur because of changes in the interest rate paid on assets denominated in a currency or because of changes in exchange risk or in concerns about inflation A reservecurrency country must pay an attractive interest rate on assets denominated in its currency and it must also take confidencebuilding measures to convince private and public holders of its currency that its currency will continue to be convertible into other sound assets and will not lose value because of inflation or changes in exchange rates Confi dencebuilding measures can be quite costly Devising an International Monetary System Differing subjective judgments and interests among public officials and intense disagreements among economists about the appropriate applicable economic model or theory add complications to the devel opment or modification of a monetary system There are intellectual and theoretical disagreements among economists and public officials about many possible solutions to the technical issues embedded in a monetary system Economists for example even disagree about the economic model to apply to determination of exchange rates and there are tradeoffs among desirable but mutually exclusive goals A choice one that is primarily political must be made At the heart of the difficulties in finding solutions to exchange rate instability is the fact that national economies have very different rates of inflation andor price instability Whereas some governments place a high value on price stability others prefer to pursue expansionary and frequently inflationary policies to reduce unemployment or stim ulate economic growth Germany and Japan having given priority to price stability throughout the postwar era have followed strong anti inflationary policies while the United States at least until the late 1970s pursued mild to highly inflationary policies The problem of devising a stable and politically acceptable interna tional monetary system is further compounded by the inevitable tradeoffs among the following equally desirable goals fixed ex change rates national independence in monetary policy and capital mobility These three goals are referred to by economists as a tri lemma or as the irreconcilable trinity Nations may want stable exchange rates to reduce economic uncertainty but they may also desire discretionary monetary policy in order to promote economic growth and steer their economies between recession and inflation In addition governments may want freedom of capital movements to 248 T H E I N T E R N A T I O N A L M O N E T A R Y S Y S T E M facilitate the conduct of trade foreign investment and other interna tional business activities 6 Unfortunately no international monetary and financial system can accommodate all three of these desirable goals fixed exchange rates national independence in monetary policy and capital mobility al though it can incorporate at most two of these objectives For exam ple a system of fixed and stable exchange rates such as the Bretton Woods System along with some latitude for independent monetary policies is incompatible with freedom of capital movement because capital flows could undermine both fixed exchange rates and indepen dent monetary policies A system with fixed exchange rates and inde pendent macroeconomic policies promotes economic stability and en ables a government to deal with unemployment However such a system sacrifices freedom of capital movement one of the most im portant goals of international capitalism A system of fixed rates and freedom of capital movements would be incompatible with an inde pendent monetary policy Different countries and domestic interest groups prefer to empha size one or another of these goals In the late 1990s the United States for example preferred independent monetary policy and freedom of capital movements and thereby sacrificed stable exchange rates The members of the European Community on the other hand preferred relatively fixed rates Some countries notably Malaysia and China placed a high value on macroeconomic independence and have im posed controls on capital movements Specific economic interests also differ in their preferences Whereas export businesses have a strong interest in the exchange rate domesticoriented businesses place a higher priority on national policy autonomy Investors prefer freedom of capital movements whereas labor tends to be opposed to such movement unless of course it means inward rather than outward in vestment As national situations and interests differ there is no one solution to the trilemma that would be satisfactory for all Many economic conservatives argue that the first major effort to resolve the problem was the most successful that is creation of the classical gold standard under British leadership in the latter decades of the nineteenth century Under that system of golden fetters to 6 The MundellFleming model developed in the 1960s by Robert Mundell and John Fleming integrates international capital flows with other factors determining demand and output This development created what has become known as openeconomy mac roeconomics in contrast to the domestic orientation of most economists in the 1960s This theoretical development is set forth in Robert A Mundell International Econom ics New York Macmillan 1968 249 C H A P T E R N I N E use the title of Barry Eichengreens important book on the subject there was indeed international monetary stability but governments had little control over their own economies and the domestic econ omy frequently suffered as a result 7 The collapse of the gold standard at the outbreak of World War I resulted in a situation in which gov ernments had too much license over economic policy the 1930s and 1940s were an era of economic anarchy competitive devaluations and beggarthyneighbor policies that lasted until the Bretton Woods System was created at the end of World War II The Bretton Woods System based on fixed exchange rates and supervised by the International Monetary Fund continued until officially terminated in the mid1970s The subsequent volatility and unpredictability of ex change rates produced by the more recent nonsystem have led to many proposals to reform the international monetary regime Reform of International Monetary Affairs In 1930 John Maynard Keynes set forth the ideal objective of an international monetary system This then is the dilemma of an international monetary systemto preserve the advantages of the stability of local currencies of the system in terms of the international standard and to preserve at the same time an adequate local autonomy for each member over its domestic rate of interest and its volume of foreign lending 8 After the breakdown of the system of fixed exchange rates in the 1970s the international monetary system strayed far from the Keynes ideal The reference range system which replaced the system of fixed rates is actually a nonsystem of floating exchange rates in which international monetary affairs are not governed by rules or understandings about such factors as rate adjustment or liquidity cre ation Or to put it another way there is no regime for international monetary affairs instead under the reference range nonsystem the central banks and finance ministers of the three dominant monetary powersthe United States Germany and Japancooperate to keep their exchange rates aligned or to change them in an orderly fashion However in this nonsystem erratic American macroeconomic poli 7 Barry J Eichengreen Golden Fetters The Gold Standard and the Great Depres sion 19191939 New York Oxford University Press 1992 8 John Maynard Keynes A Treatise on Money The Applied Theory of Money Cambridge Cambridge University Press 1971 first published in 1930 272 250 T H E I N T E R N A T I O N A L M O N E T A R Y S Y S T E M cies and huge trade deficits have caused large exchange rate fluctua tions and have seriously vexed Americas trading partners The reference range nonsystem represents the triumph of the cen tral bankers Stability of the international monetary system has rested mainly on informal cooperation among the American Federal Re serve the German Bundesbank replaced in 1999 by the Central Eu ropean Bank and the Bank of Japan which have intervened in cur rency markets to protect the integrity of the system prevent financial instability and stabilize exchange rates through secret agreements and sporadic intervention in the market After the disturbing experi ence of hyperflation in the 1970s interbank cooperation has also been employed to suppress inflationary tendencies However many critics especially on the political left have denounced this interna tional alliance of conservative bankers as the cause of high unemploy ment and even of the global economic crisis of the late 1990s Many economists believe that this system of informal cooperation among central bankers and finance ministers is the best possible solu tion to the problems of the international monetary system They reject the contention that fluctuating exchange rates have a negative impact on economic affairs and argue that if this should happen exchange rate volatility could be managed through currency hedging and other techniques Other economists and central bankers on the other hand believe that the present nonsystem should be replaced by a rulebased monetary system or more institutionalized cooperation A serious problem they point out is that there are radical fluctuations in ex change rates that cause uncertainty and thereby inhibit trade and in vestment exchange rate uncertainty also is alleged to encourage such regional monetary arrangements as the European Monetary Union 9 Many economists and public officials who worry about this and other weaknesses in the reference range system believe that a fundamental reform of the international monetary system is urgently needed Since the collapse of the Bretton Woods System of fixed rates the issue of fixed versus flexible exchange rates has been central to all questions of international monetary reform At the heart of this de bate are the irreconcilable trinity and the difficult choices it poses for national governments In general economists prefer flexible rates in order to facilitate international capital movements and adjustments 9 Whether fluctuations in currency values are actually harmful is a matter of debate among economists For a discussion of the issue consult Ronald I McKinnon and K C Fung Floating Exchange Rates and the New Interbloc Protectionism Tariffs ver sus Quotas in Dominick Salvatore ed Protectionism and World Welfare New York Cambridge University Press 1993 10 251 C H A P T E R N I N E in the real economy made necessary by economic shocks Central bankers and a minority of economists prefer fixed rates in order to ensure price stability A number of conservative economists and oth ers prefer a return to the nineteenthcentury gold standard as it would eliminate government control over monetary affairs and pre vent inflation Most economists reject this proposal because it would also eliminate the ability of governments to manage their economies in the case of recession or an economic shock Whether one prefers the macroeconomic independence that comes with flexible rates or the microeconomic benefits that accompany stable exchange rates is at the core of this debate Arguments for More Stable Exchange Rates Advocates of a return to more stable exchange rates assert that the experiment with flexible floating rates has failed and that flexible rates have resulted in excessive currency and price volatility destabi lizing international capital flows and inflationary economic policies Excessive exchange rate volatility increases uncertainty and risk in both international trade and foreign investment and thus impedes in ternational economic integration Some experts also argue that vola tility of currency values has decreased the effectiveness of the price mechanism and of the principle of comparative advantage as tools in international trade and foreign investment decisionmaking Erratic swings in the three major currencies have occurred within a period as short as one or two years swings in which some currency values have varied by as much as 30 to 40 percent For example the dollars value moved from 250 yen in 1985 to 79 yen in 1995 back up to 148 yen in 1998 and then down again to 105 in early 2000 10 The resulting uncertainty in relative prices made it almost impossible to calculate relative costs and comparative advantage calculations needed for a market economy to function efficiently From such expe riences some have concluded that floating rates impose high costs in economic growth and in the efficient allocation of economic re sources even arguing that unstable exchange rates have contributed to trade protectionism These individuals believe that fixed rates on the other hand provide international discipline over inflationary monetary policy reduce uncertainty that interferes with trade and investment and thereby facilitate competition based on comparative advantage and efficient capital flows 10 Robert Mundell Threat to Prosperity Wall Street Journal 30 March 2000 A30 252 T H E I N T E R N A T I O N A L M O N E T A R Y S Y S T E M Proponents of more stable exchange rates are fully aware that eco nomic and political developments have made impossible a return to the type of peggedrate system laid down at Bretton Woods These individuals advocate instead a compromise between greater interna tional stability and provision of some flexibility for the policies of individual governments Many are concerned because governments need to be able to respond to economic shocks and other develop ments through various schemes based on the idea of a contingent exchange rate target the schemes have such labels as pegged but ad justable exchange rates crawling peg managed floating rates adjustable peg and exchange rate target zones Whatever the exact formulation Nobel Laureate Robert Mundell believes that a more stable international monetary system requires close cooperation among the three major currencies 11 As such cooperation would entail restraints on American economic policy its political prospects are not promising Arguments for Flexible Exchange Rates Fixed stable exchange rates are very costly to maintain in a world with huge international financial flows These financial flows have become the principal determinant of exchange rates a role previously played by trade flows Therefore unless a country is willing either to shut itself off from international investment or to give up the possibil ity of an independent macroeconomic policy two of the components of the irreconcilable trinity it must accept flexible floating rates A system of flexible exchange rates provides the least costly means for economies to adjust to external shocks like the 1973 rise in oil prices Proponents of flexible rates argue that when a government faces a balance of payments disequilibrium it is far better to devalue its currency than to deflate its economy or resort to capital controls The value of a currency should be free to change so that other more important values or real variables such as wages and employment need not change Indeed the flexible rates in existence in 1973 made the necessary adjustments easier than they would have been if there had been fixed rates which during the oil crisis would have forced countries to adjust to the price rise either through severe deflation or capital controls Advocates of floating rates argue that they are inherently desirable because the value of a currency acts as a balancing mechanism for the rest of the economy and because flexible rates protect and cushion an 11 Ibid 253 C H A P T E R N I N E economy from disturbances originating in the international economy While there may be some problems of uncertainty and inflation asso ciated with flexible rates reliance on fixed rates to avoid such prob lems makes adjustment both more costly and more difficult Many argue moreover that the costs of floating rates have been greatly exaggerated they point out that the problem of monetary uncertainty can be reduced by private firms hedging in the foreign exchange market Monetary expert Barry Eichengreen argues that economic and po litical changes have made a return to a system of fixed rates impossi ble 12 One change is the institutionalized structure of labor markets associated with the welfare state a development that seriously re stricts the fluidity with which prices and wages can adjust to eco nomic shocks Another important change is the increasingly politi cized environment in which domestic monetary policy must be formulated politicization of macroeconomic policy in almost every democratic country has eroded the credibility of government policies and the commitment of monetary authorities to pursue noninflation ary monetary policy As the twentyfirst century opened few govern ments could be relied upon to maintain longterm robust or steadfast monetary policy The most important change is the greatly increased mobility of capital movements around the world that has been en couraged by deregulation of capital markets technological develop ments and new financial instruments all of which have also greatly limited governmental ability to contain market pressures Eichengreen argues that these economic and political changes have restricted possible international monetary arrangements to either 1 an international monetary system based on freely floating exchange rates or 2 monetary unification among groups of countries to en able creation of single currency areas managed by regional central banks Freely floating exchange rates would be a step away from an integrated rulebased world economy as such an arrangement could have few if any rules governing such technical matters as exchange rate adjustment and liquidity creation Under such a monetary ar rangement an individual nation could intervene in the market to guide the floating rate of its currency but could not set and hold to a targeted value Therefore the means to guarantee a stable interna tional monetary system Eichengreen has argued is complete mone tary integration that is creation of a single currency managed by a 12 Barry J Eichengreen International Monetary Arrangements for the 21st Century Washington DC Brookings Institution 1994 254 T H E I N T E R N A T I O N A L M O N E T A R Y S Y S T E M central bank However as the twentyfirst century opened the only effort to achieve monetary unity was that in Western Europe Many economists and public officials believe that Eichengreens analysis is much too pessimistic and few are willing to give up the search for an effective means to stabilize exchange rates through an international monetary authority international policy cooperation or some other mechanism However many would undoubtedly agree that an effective governance mechanism must soon be devised to man age international monetary affairs in order to avoid the real danger that the monetary system will disintegrate either into monetary anar chy similar to the 1930s or will fragment into regional arrangements based on such dominant regional currencies as the American dollar the euro or the Japanese yen A stable international monetary system must rest on the cooperation of the major economic powers a situa tion that has not been easy either to establish or to maintain Unity or Fragmentation of the Monetary System Creation of the European Monetary System EMS and the common currency euro pose a serious threat to the unity of the international monetary system There is considerable interest and disagreement among public officials economists and political pundits on both sides of the Atlantic Ocean and in other parts of the globe concerning the implications of the euro for the dollar and the international econ omy in general The most important questions are whether or not the euro will displace the dollar as the worlds principal currency what the consequences for the United States would be if it did and how the euro would affect the functioning and management of the interna tional monetary and economic system The large number of economic and political unknowns surrounding the euro make it impossible to provide any conclusive answers to these and other relevant questions Nevertheless these issues are of such moment for the future of the global economy that they must be addressed even if only tentatively Throughout the postwar era the international role of the dollar has been an important feature of the world economy Somewhere between 40 and 60 percent of international financial transactions are denominated in dollars For decades the dollar has also been the worlds principal reserve currency in 1996 the dollar accounted for approximately twothirds of the worlds foreign exchange reserves The possibility that the euro will replace the international role of the dollar as a transaction and reserve currency has become extremely important particularly for the United States and its financial commu 255 C H A P T E R N I N E nity In Western Europe many believe that eventually the euro will to a significant degree displace the dollar On the other hand most American economists believe that the euro is unlikely to displace the dollar They believe moreover that if a shift from the dollar to the euro should occur it would happen very slowly over a lengthy period and thus give the United States sufficient time to make such necessary adjustments as elimination of its huge tradepayments deficit Most American economists expect that the continuing international role of the dollar will depend more on the strength of the American economy than on anything else and that the importance of the dollar to international financial markets will be determined primarily by the international competitiveness of the American financial system The euro according to this position could replace the dollar only if West Europeans create an integrated and efficient financial market Many doubt that this will happen for some time Thus American officials and economists tend to discount the possibility that the international reign of the dollar will be undermined by the euro at least in the foreseeable future If the euro were to replace the dollar as the worlds key currency there would be important implications for both private American fi nancial interests and the American government The success of the euro could have a large negative impact on American banks and fi nancial institutions because a large volume of transactions in a cur rency leads to economies of scale and decreased transaction costs The larger the volume of currency transactions in a particular coun trys currency the greater the profits and competitiveness enjoyed by the banks and financial institutions of that country If the euro were to replace the dollar as a reserve or transaction currency then the benefits of scale and lower transaction costs would be transferred from American to European financial institutions By one estimate the portfolio switch from the dollar to the euro could be as large as 1 trillion The international role of the dollar has conferred a number of eco nomic and political benefits on the United States and if the dollar were to lose its status as the worlds key currency the United States would forfeit these benefits The international demand for dollars has meant that the United States has been able to finance its huge and continuing tradepayments deficits since the early 1980s at a minimal cost In effect the United States government has been able to assume that other countries would automatically finance its tradepayments deficit because others needing dollars to conduct their international business did not demand high interest rates Moreover the United 256 T H E I N T E R N A T I O N A L M O N E T A R Y S Y S T E M States has been able to borrow in its own currency and thus avoid exchangerate risks Many of the dollars in circulation are overseas in the hands of nonAmericans this socalled dollar overhang of about 265 billion is the equivalent of an interestfree loan to the United States that some have estimated to be worth about 13 billion in annual interest payments In addition American prestige is cer tainly enhanced by the international role of the dollar Many West European leaders believe that the euro will greatly strengthen their political position visavis the United States in inter national economic negotiations The euro could eliminate the nearly automatic financing of the American balance of payments deficit and limit the considerable financial freedom the United States has had to pursue its independent economic and foreign policies In addition a successful euro could undercut Japans ambition to have the yen play a much larger role as an international currency In a global economy composed of three major currencies the Japanese fear that the yen could become the odd man out Growing concern about such a possibility has in fact stimulated Japan to propose a global cur rency triumvirate of the dollar the euro and the yen an arrange ment that would be managed by the three major economic powers The real or even the perceived threat that the euro could displace the dollar could trigger a serious conflict between Western Europe and the United Statesand possibly Japan as well thus creating a threeway struggle If a struggle were to erupt between the dollar and the euro similar to the earlier struggle for supremacy between the dollar and sterling in the 1920s and 1930s considerable economic and political costs could be incurred by such a transatlantic conflict The united international monetary system could fragment into re gional blocs centered on the euro the dollar and possibly the yen At the beginning of the twentyfirst century a number of smaller countries were considering whether to tie their currencies to the cur rency of their dominant trading partner The possibility of the development of currency blocs arises from the belief that currency blocs would reduce exchange rate risk among member countries as is happening in Western Europe such a change would be especially important for countries that trade heavily with one another and was a major reason for creation of the Economic and Monetary Union EMU 13 A common currency could also en 13 Zanny Minton Beddoes From EMU to AMU The Case for Regional Curren cies Foreign Affairs 78 no 4 JulyAugust 1999 813 257 C H A P T E R N I N E courage a low rate of inflation among member countries provided that the leading country maintained a low inflation rate this was the case in the Exchange Rate Mechanism where West Germany was the leading economy The major economic disadvantage of a currency bloc or union is loss of national independence in macroeconomic pol icymaking However the most serious risk in currency blocs is that they could intensify the already strained political relations among the United States Japan and Western Europe Few or Many National Currencies Another possible threat to a unified global monetary system arises from dollarization of national currencies The term dollarization refers to the decision of a less developed country to tie its currency closely to the dollar or to accept the dollar as its currency Argentina has chosen the first option and Panama and Ecuador the second More broadly dollarization refers to the use by one country of any major currency including the euro or the yen For a less developed country the purpose of dollarization would be to stabilize its cur rency and exchange rate and to dampen inflation dollarization would also reassure investors that in the event of a crisis they would be compensated in a hard currency A number of American policymak ers believe that the use of dollars by LDCs would strengthen the dol lar against the euro Advocates of dollarization allege that in the era of globalization and massive financial transactions across national borders a world with more than one hundred currencies is grossly inefficient and can not possibly continue over the long term 14 Dollarization would result in a reduction of transaction costs and this makes dollarization like fixed rates and a regional currency very attractive to business execu tives The financial and exchange rate crises of the late 1990s revealed the vulnerability of weaker currencies By tying these currencies to stronger currencies dollarization would stabilize and protect from market instabilities the weaker currencies of less developed countries Nevertheless despite the apparent attractiveness of dollarization many economists believe that it would actually prove harmful to less developed countries 14 Ricardo Hausmann Should There Be Five Currencies or One Hundred and Five Foreign Policy no 116 fall 1999 6579 258 T H E I N T E R N A T I O N A L M O N E T A R Y S Y S T E M The arguments for and against dollarization are similar to those for and against fixed exchange rates and regional currencies 15 Dollar ization enforces fiscal and monetary discipline on the less developed country and reduces monetary uncertainty These restraints discour age irresponsible macroeconomic policies Moreover dollarization like a fixed exchange rate reduces uncertainty and transaction costs Most importantly dollarization would reduce currency speculation and the likelihood of financial crises and of competitive devaluations Although dollarization could be very important most economists believe that its possible benefits are far outweighed by the advantages of flexible exchange rates Arguments against dollarization and for a flexible exchange rate emphasize that the exchange rate functions as a safeguard for the real economy In effect an exchange rate appreci ation or depreciation acts as a shock absorber For example a drop in demand for an economys exports can lead to slower economic growth and increased unemployment It would then be possible of course to permit wages to fall However the reduction of wages across an economy is a long and politically difficult process A more simple solution would be to depreciate the currency and this in turn would decrease the price of the countrys exports and increase de mand thereby benefiting the economy One should recall however that what is good for a major country may not be good for a smaller economy For example an LDC whose currency is tied to the dollar may wish to stimulate its economy whereas the United States may not wish to do so Stimulus of the LDC economy would lead to a reduction of its dollar reserves and eventually cause the expansion of its economy to stop In effect the LDC ties its monetary policy and management of its economy to the larger countrys policies if it adopts dollarization Conclusion Despite economists justified skepticism of dollarization and a drastic reduction in the number of national currencies it seems inevitable that over the long term smaller economies will link their currencies closely to their major trading partners By the end of the twentieth century LDCs were already tying their currencies to the dollar euro or yen However this slowmoving development does not necessarily 15 Jeffrey Sachs and Felipe Larrain Why Dollarization Is More Straitjacket Than Salvation Foreign Policy no 116 fall 1999 8092 259 C H A P T E R N I N E mean either that three currency blocs will emerge or that the global economy will fracture Nevertheless the possibility that currency blocs may emerge makes clear the need for improvements in policy and monetary cooperation among the United States Japan and West ern Europe In the meanwhile public officials central bankers and economists should and do continue to search for a compromise that would achieve Keyness stated objective for an international monetary system that is international currency stability along with domestic policy flexibility Although the economics literature is replete with schemes to achieve these dual goals this can happen only if political cooperation among the major economic powers is achieved first 260 CHAPTER TEN The International Financial System T HE FINANCIAL REVOLUTION of the 1970s was a major devel opment in the postwar international economy 1 Removal of capi tal controls by leading economies and the consequent freedom of cap ital movement resulted in increased integration of national capital markets and creation of a global financial system Emergence of an international financial market has greatly facilitated efficient use of the worlds scarce capital resources and has enabled capitalpoor LDCs to borrow funds for economic development On the other hand international capital flows have increased the instability of the international economy The international financial system itself is in herently unstable and subject to serious crises Despite its importance the nature and the extent of the global integration of financial matters are poorly understood outside the economics and financial communi ties Partial Globalization of International Finance International finance is the one area to which the term economic globalization clearly applies Globalization of finance has become a crucial and distinctive feature of the world economy The interna tional movement of capital has integrated economies around the world The daily turnover in currency exchanges increased from 15 billion in 1973 to 12 trillion in 1995 the equity and bond markets also grew and became more global The ability to move billions of dollars from one economy to another at the push of a button has transformed international finance and increased its impact on both international and domestic economies However it is important to place these developments like other aspects of economic globaliza tion in proper perspective Despite the impressive numbers that describe the international fi nancial system in relative terms the volume of financial flows at the beginning of the twentyfirst century is still not equal to the interna 1 This chapter draws from Chapter 5 of Gilpin The Challenge of Global Capitalism Princeton Princeton University Press 2000 261 C H A P T E R T E N tional flow of capital at the end of the nineteenth century Prior to World War I for example the British invested approximately one half of their savings abroad Between 1880 and 1913 British capital exports averaged 5 percent of GNP and at their peak reached almost 10 percent of GNP In contrast although the world marveled at Japa nese capital export in the 1980s and early 1990s Japan actually ex ported only the equivalent of 2 to 3 percent of its GNP We should also remember that preWorld War I British investments were largely in railroads port facilities and other infrastructure that provided physical foundations for the highly interdependent international economy developing at that time Without substantial British overseas investment in the United States and other lands of recent settle ment these countries would not have developed at the rate they did achieve Today a substantial portion of international capital flows are shortterm six months or so and highly speculative and there is controversy concerning the extent to which they actually contribute to world economic development Although internationalization of finance has become an important feature of the global economy the international financial system con tinues to be largely nationally based and consists of closely intercon nected discrete national financial systems Some countries such as Japan and China even retain controls on capital flows Moreover in the prosaic language of economics finance is still characterized by a powerful home bias effect Investors tend to invest in their home economies rather than to maintain internationally based investment portfolios In the 1990s for example 94 percent of the stocks in the American stock market and 98 percent of the stocks in the Japanese stock market were domestically owned and Japanese financial mar kets were closely regulated by the powerful Ministry of Finance However one should note that the home bias tendency may be lessening even though the world is still characterized by national fi nancial markets An important study by Martin Feldstein and Charles Horioka found that increased freedom of capital movement has not integrated international finance as much as many believe 2 If the world were really integrated in financial matters then national savings rates and investment rates would no longer be closely correlated and interest rates around the world would be more nearly equal If capital were fully mobile investment in a particular country would depend on the 2 Martin Feldstein and C Horioka Domestic Savings and International Capital Flows Economic Journal 90 1980 31119 262 T H E I N T E R N A T I O N A L F I N A N C I A L S Y S T E M investment opportunities in that economy and would not be highly correlated with the savings rate in that nation The fact is however that savings and investment are closely correlated highsaving coun tries such as Japan tend to be highinvesting countries and vice versa for lowsaving countries The United States is a major exception to this generalization in that domestic investment significantly exceeds national savings and is dependent on foreign borrowing Moreover in a perfectly integrated international financial system the cost of capital discounting the risk factor would be approximately equal everywhere instead significant national differences in capital costs remain characteristic of the world economy Despite these caveats the globalization of finance is a reality and it does have profound consequences for the international economy The absolute size the high velocity and the global scope of financial movements have been very important in the postwar period In partic ular the increased importance of speculative shortterm investments by financiers such as George Soros by hedge funds in emerging markets and by international banks have significantly increased the vulnerability of the international financial system and the world econ omy more generally speculative funds amount to hundreds of billions of dollars Many economists and public officials believe that these shortterm speculative flows increasingly threaten the stability of the global economy and should therefore be regulated Financial crises are a recurrent feature of the international econ omy Even prior to the 1997 East Asian crisis the postwar interna tional economy had experienced several serious crises three were es pecially important The first resulted from the debt problems of many less developed countries in the late 1970s and early 1980s a number of LDCs in Latin America and elsewhere had borrowed heavily from commercial banks in the mid1970s and were thus highly vulnerable to the global recession of the late 1970s The second was the 1992 1993 collapse of the European Rate Mechanism that forced Great Britain to withdraw from the effort to create a common European currency and resulted in fragmentation of the movement toward monetary unity The third crisis was the collapse of the Mexican peso in 19941995 which threatened to precipitate a general financial cri sis throughout Latin America only the quick intervention of the Clin ton Administration averted such a crisis These earlier crises were concentrated in particular regions did not threaten the larger international economy and were managed rela tively easily at least when compared to the East Asian financial crisis of 1997 That crisis was vastly different The endofthecentury crisis 263 C H A P T E R T E N began in the most economically robust region of the world its conse quences were truly devastating for that region and the crisis eventu ally spilled over into the larger global economy It is reasonable to say that the crisis resulted at least in part from globalization and transformations in modern finance huge shortterm investments in the region by international banks and financiers made these countries highly vulnerable to sudden swings in investor preferences Neverthe less as I have argued elsewhere the risky policies undertaken by gov ernments in the region must assume much of the blame 3 The severity of the crisis led many to believe that international financial move ments must be made subject to some regulatory mechanism Nature of Financial Crises Recurrent financial crises cause one to question the rationality of mar kets and to ask how rational actors can become caught up over and over again in investment booms or manias that almost invariably re sult in financial panics and crises Or to put the matter another way if economic actors are rational as economists assume them to be how can one account for the frequent utter irrationality of financial markets As Charles Kindleberger has written over the past several centuries the world economy has been subject to a series of financial manias panics and crashes to use the title of his book that have shaken international capitalism 4 Some economists have even argued that economic and institutional changes have made serious financial crises impossible and that if crises were to occur they would be caused by unique historical circumstances and would certainly not be caused by the inherent workings of the capitalist system Given such attitudes in the profession it is not surprising that few economists anticipated the East Asian or global financial turmoil The generally dismissive attitude of professional economists to the dangerous and destabilizing consequences of international financial crises has been challenged by Hyman Minsky a maverick economist hardly at the forefront of the discipline In a series of articles spanning a number of years Minsky set forth what he called the financial instability theory of financial crises 5 According to his theory finan 3 Gilpin The Challenge of Global Capitalism Chapter 5 4 Charles P Kindleberger Manias Panics and Crashes A History of Financial Cri ses New York Basic Books 1979 5 This discussion of Minskys theory of financial crises is based on Kindlebergers Manias Panics and Crashes A History of Financial Crises Minskys writings on the subject can be found in Hyman P Minsky Can It Happen Again Essays on Insta bility and Finance Armonk NY M E Sharpe 1982 264 T H E I N T E R N A T I O N A L F I N A N C I A L S Y S T E M cial crises are an inherent and inevitable feature of the capitalist sys tem and they follow a discernible and predictable course The events leading up to a financial crisis begin with what he calls a displace ment or an external shock to the economy this external shock which must be large and pervasive can take such different forms as the start of a war a bumper or a failed crop or innovation and diffu sion of an important new technology If large and pervasive enough the externalexogenous shock increases the profit opportunities in at least one important economic sector while simultaneously reducing economic opportunities in other areas In response to a shift in profit opportunities a number of businesses with adequate financial re sources or lines of credit rush into the new area and abandon existing areas If the new opportunities turn out to be sufficiently profitable an investment boom or mania begins Rapid and substantial expansion of credit is a key aspect of an investment boom this greatly expands the total money supply Even though as Minsky points out bank credit is notoriously unstable an investment boom is fueled as well by personal and business funds used to finance the speculative boom and thereby add further to the money supply and expansionary activity In time the urge to specu late drives up the price of the soughtafter goods or financial assets The price rise in turn creates new profit opportunities and draws more investors into the market This selfreinforcing or cumulative process causes both profits and investments to rise rapidly During this euphoria stage to use Minskys apt word speculation on price increases becomes yet another important factor driving up the mar ket More and more investors lusting after the rewards of rising prices and profits forsake normal considerations of rational invest ment behavior and invest in what by its very nature is a highly risky market This irrational development is the mania or bubble phase of the boom As the mania phase accelerates prices and the velocity of speculative monies increase At some point along this path of speculation a few insiders believ ing that the market has reached its peak begin to convert their in flated assets into money or quality investments As more and more speculators realize that the game is about over and begin to sell their assets the race to get out of risky overvalued assets quickens and eventually turns into a stampede toward quality and safety The specific event or market signal that triggers the rout and eventually causes a financial panic may be a bank failure a corporate bank ruptcy or any number of untoward events As investors rush out of the market prices fall bankruptcies increase and the speculative 265 C H A P T E R T E N bubble eventually bursts causing prices to collapse Panic follows as investors desperately try to save what they can Banks frequently cease lending and this causes a credit crunch a recession or even a depression may follow Eventually the panic ceases through one means or another the economy recovers and the market returns to an equilibrium having paid an enormous price Economists with a few notable exceptions reject Minskys model of financial crises because they believe no general model of financial crises can be formulated as every crisis is either unique or of a very particular type for which a specific model is required They consider every financial crisis to be a historical accident not amenable to gen eral theorizing A further criticism is that Minskys model of financial crises assumes that such crises are generated by uncertainty specula tion and instabilityand economists assume rationality and brush away such awkward aspects of economic behavior Nobel Laureate Milton Friedman for example has even proclaimed that because eco nomic actors are at all times rational speculation cannot occur in a market economy In fact he argues that what most of us call specu lation is the effort of investors to protect themselves from the irra tional actions of governments Minsky on the other hand considered irrationality euphoria and financial crises inherent features of modern capitalism In Kindlebergers formulation even if one were to assume the rationality of the individual investor the historical record demonstrates over and over that even markets themselves sometimes behave in irrational ways and that mob psychology provides the best explanation of financial manias Although individuals may be rational financial speculation is a herd phenomenon in which the seemingly rational actions of many individuals lead to irrational out comes Although Kindleberger is reluctant to declare that financial crises are an inherent feature of domestic capitalism he asserts that they are inherent in international capitalism He argues that Minskys model is applicable to the realm of international finance where one finds those essential features of an international financial crisis that were set forth by Minsky Risky speculation monetary credit expansion a rise in the price of desired assets a sudden and unexpectedly sharp fall in the price of the assets and a rush into money or quality investments are endemic in the international pursuit of high profits by interna tional investors The East Asian financial crisis and subsequent global financial turmoil did indeed closely follow Minskys model Specula tive investment in emerging markets by international banks and highly leveraged hedge funds fueled the mania and the investment 266 T H E I N T E R N A T I O N A L F I N A N C I A L S Y S T E M bubble until the collapse of the Thai baht on July 2 1997 signaled the end of the East Asian miracle Somewhat over a year later in midAugust 1998 devaluation of the Russian ruble and other bad news from Russia triggered global financial turmoil The East Asian Financial Crisis In the summer of 1997 East Asian economies suffered a devastating blow Economies that only four years earlier had been hailed by the World Bank as exemplars of pragmatic orthodoxy and as remark ably successful in creating and sustaining macroeconomic stability experienced the worst economic collapse of any countries since the 1930s and were declared victims of their own irresponsible ways Beginning in Thailand in early July the crisis spread rapidly up the East Asian coast and engulfed every nation in Southeast and East Asia It had previously been unthinkable given modern economic knowledge that a financial crisis of this magnitude could occur In fact no one had predicted the crisis In retrospect however a crisis of some sort appears to have been inevitable given all the things that could and did go wrong in the months preceding it In the language of social science the East Asian financial crisis was overdetermined If one cause had not plunged the East Asian economies into crisis there were half a dozen others that might have done so The East Asian economic crisis made more credible to many people the charge that economic globalization has significantly increased in ternational economic instability and has been harmful to domestic societies It is certainly undeniable that the economic plight of East Asia attests to the ability of international financial markets to wreak havoc on domestic economies However imprudent domestic eco nomic policies were as important as global economic forces in making these economies highly vulnerable to sudden shifts in international financial flows Many of the allegedly negative effects of economic globalization are actually due either to poor economic management by governments or to developments that have nothing whatsoever to do with economic globalization The victims in these situations have generally been small economies The United States has run a trade payments deficit for approximately three decades without unleashing any dire consequences While large states with large markets and re sources may be able to defy economic forces for a long time such a privilege is rarely accorded to small states especially small states with such reckless policies as borrowing short and lending long that 267 C H A P T E R T E N is those who finance longterm development and risky projects with short maturity funds It is extraordinary that there is no mechanism to regulate interna tional finance Even though the world economy experienced three ma jor financial crises in the 1990sthe 19921993 crisis of the ERM the 19941995 MexicanLatin American crisis and beginning in 1997 the East Asian crisisefforts to create effective regulations governing international capital flows and financial matters have not made much progress A number of scholars including Paul Kindle berger Susan Strange and James Tobin note that the international financial system is the weakest link in the chain of the international economy and that international finance should be regulated effec tively Financial markets these scholars have argued are too subject to irrational manias and crises and cannot police themselves In such a situation it is quite unfair to blame the East Asian crisis solely on the forces of economic globalization and on wicked Western speculators like George Soros Although destabilized financial markets will eventually return to an equilibrium the crises can impose an unacceptably heavy cost on innocent bystanders and on the larger world economy For this rea son scholars such as Kindleberger Strange and Tobin advocated es tablishment of international regulations or a formal regime to govern financial markets For example Tobin and others have proposed an international tax to discourage financial speculation especially in shortterm investments Others such as George Soros go farther and argue that creation of an international central bank and true lender of last resort should be at the heart of a mechanism to govern inter national finance that is an authority should be created to function internationally as central banks do domestically Then when a gov ernment finds itself in trouble the international bank could step in to rescue it It is not necessary to say that the prospects of establishing such an international central bank are quite remote at least under the political conditions of the early twentyfirst century In the late summer of 1998 the East Asian economic crisis spilled over into the global economy setting the stage for what President Clinton declared the worst economic crisis in fifty years The Russian governments devaluation of the ruble against the German mark by about 40 percent in late August triggered the globalization of the crisis The Clinton Administration for political reasons had bet heavily on saving Russia and had pressured the IMF to loan Russia tens of billions of dollars many of which were subsequently squan dered and funneled to private Russian accounts in foreign banks In vestors and governments around the world panicked as they wit 268 T H E I N T E R N A T I O N A L F I N A N C I A L S Y S T E M nessed a major nuclear power reneging on its agreements and facing economicpolitical chaos Worried that other countries would also de fault investors searching for safe havens in the early fall of 1998 began to withdraw funds from LDCs Declining corporate profits and investor panic led to a precipitous fall of the American and other stock markets October 31 1998 The threat that the LongTerm Management Fund would collapse greatly deepened the crisis These events in turn set off a serious credit crunch that further slowed global economic growth Late that fall some estimated that approximately onethird of the world economy was in recession the United States alone was still experiencing economic growth With the depression in East Asia and recession in much of the rest of the world commodity prices fell considerably and this caused economic distress in many commodityexporting sectors including American agriculture American officials had become concerned in the early fall that the financial crisis would continue to spread and had focused much of their attention on Brazil Brazil possessed many of the characteristics of a developing economy in serious trouble including a huge budget deficit and sizable international debt The countrys uncertain fiscal situation was accompanied by a heavy capital outflow and put severe pressure on the Brazilian real The Clinton Administration feared that financial collapse in Brazil a major importer of American products would seriously damage the American economy and accelerate tur moil throughout the world As the troubles of the global economy continued to unfold the Administration took action In a wellpubli cized speech in midSeptember to the New York Council on Foreign Relations the President proposed that all the major economic powers stimulate their own economies in order to restore global economic growth he also proposed that the major economic powers should meet at the time of the next IMFWorld Bank meeting in October and should then develop a longerterm solution to the problem of global financial instability These Clinton initiatives were given a cool reception Every central bank ignored the suggestion that interest rates be cut in order to stim ulate global growth Nevertheless on October 15 the Federal Re serve motivated primarily by concerns about the American economy did cut interest rates it did so twice more before the end of Novem ber These important moves restored investor confidence and suc ceeded in reinvigorating the American economy The other major eco nomic powers had agreed although without enthusiasm to Clintons proposal that they meet and that meeting took place during the an nual joint meeting of the IMF and World Bank WB that was held in Washington in late October 269 C H A P T E R T E N At the IMFWB meetings President Clinton set forth proposals for a new international financial architecture to contain the spreading economic crisis and prevent future crises The Administration also hoped to forestall efforts by other governments mainly Western Eu rope and Japan to impose new restrictions on international capital flows The Presidents proposals were considered at the October 30 meeting of the major economic powers and several important decisions were reached The G7 assuming that if investors were fully aware of risky situations they would not repeat the mistakes made in Mexico 19941995 and in East Asia agreed that much greater transparency of financial conditions in every country was crucial to prevention of future financial crises In addition the G7 called for much tighter inter national standards for accounting and for bank regulation The most important G7 decision was to accept Clintons proposal that the IMF should establish a 90 billion contingency fund to pro vide countries with emergency financial assistance the fund would help only those countries already carrying out economic reforms and those whose economic fundamentals were basically sound Before a crisis actually occurred this would enable the IMF to intervene in order to shore up the countrys financial defenses of its currency by providing adequate liquidity and thereby preventing financial panic When it made this proposal the Clinton Administration had Brazil in mind as Brazil required a huge infusion of foreign capital to keep its economy afloat Following a bruising but ultimately successful bat tle in the Congress over replenishment of IMF funds much of which had previously been squandered in Russia in November the IMF of fered Brazil a large assistance package of over 40 billion and attached a precondition that the Brazilian economy be significantly overhauled In early 1999 having failed to improve its economic per formance Brazil suffered a major economic crisis As important as the G7 decisions had been they failed to quell the intense controversy over reform and regulation of the international financial system By early 2000 a number of proposals had been for mulated to deal with destabilizing international financial flows cur rent proposals range from creation of a worldwide central bank to imposition of an international tax on financial transfers across na tional boundaries called the Tobin tax 6 Some experts believe that 6 An excellent discussion of international financial reform is Barry J Eichengreen Toward a New International Financial Architecture A Practical PostAsian Agenda Washington DC Institute for International Economics 1999 Also Council on For eign Relations Safeguarding Prosperity in a Global Financial System The Future Inter national Financial Architecture Report of an Independent Task Force New York Council on Foreign Relations 1999 270 T H E I N T E R N A T I O N A L F I N A N C I A L S Y S T E M selfimposed national restrictions on both financial inflows and out flows are necessary A number of governments such as Japan China Malaysia and Chile have in fact instituted controls on financial flows The European Union too has begun consideration of some regional regulations on capital flows Controversy over Regulation of International Finance With the global financial turmoil of the late 1990s the economics profession and many governments became concerned about and deeply divided over international finance and regulation of interna tional capitalinvestment flows Many American economists believed and certainly the Clinton Administration did that international fi nancial flows perform a crucially important role and that such flows should be free from government regulation Most economists also believe that the financial system should ensure that capital moves from economies with surplus savings to those where investment op portunities exceed local savingsthat capital should be free to move toward those places and activities where it will be used most effec tively and will thereby increase efficient utilization of the worlds scarce capital resources The prevailing opinion in the United States is that markets rather than governments or international organizations should govern the international financial system At least since the time of the Reagan Administration the United States government has strongly believed that American financial interests benefit greatly from freedom of capital movements and it has made a concerted effort to open foreign economies to those investments The Clinton Administration led first by Treasury Secretary Robert Rubin and Deputy Secretary Lawrence Summers and later by Summers as Trea sury Secretary enthusiastically carried this effort forward However the East Asian financial crisis caused some American economists and many governments concern about the frequently dev astating impact of international financial movements A number of prominent economists in the United States and elsewhere challenged the value of unrestricted international capital flows arguing that al though it has been amply demonstrated that international trade bene fits the global economy the benefits of free capital movements have not been adequately demonstrated On the other hand the costs to the international economy of frequent financial crises have become painfully obvious Indeed as Kindleberger has shown international financial history does record constantly recurring speculative manias panics and crises Therefore many have concluded that international 271 C H A P T E R T E N financial matters should not be left entirely up to the free play of market forces but that some rules or mechanisms to regulate interna tional capital movements should be devised Unfortunately economists disagree over the cost and desirability of international financial flows Although they agree on the virtues of trade liberalization no comparable agreement exists with respect to capital flows and whether or not they should be regulated It is worth noting for example that six of Americas most distinguished econo mistsJagdish Bhagwati Stanley Fischer Milton Friedman Paul Krugman Jeffrey Sachs and Joseph Stiglitzhave disagreed with one another vehemently and not always in a friendly spirit regarding analysis of the East Asian financial crisis and the policies that should be pursued to prevent future crises While some believe that gover nance of the international financial system should be left entirely up to the market other economists and the IMF favor freedom of capital movements along with greater IMF surveillance over both domestic and international financial matters A number of countries including Japan Germany and France believe that greater international con trols are required over monetary and financial matters Reliance on the Market Those economists who believe that a completely open and unregu lated international financial system is the only realistic way to deal with the problems resulting from international financial flows also believe that any other approach necessarily raises the problem of moral hazard Moral hazard would be a problem because if lend ers and borrowers were to believe that the IMF or another official agency would rescue them from their folly they would be encouraged to engage in reckless behavior indeed this had happened in the East Asia financial crisis On the other hand an unregulated financial mar ket would itself punish investors and borrowers who failed to pursue prudent economic behavior If international investors realized that no one would rescue them if they got into trouble they would become more cautious with their investments Milton Friedman Walter Wriston George Schultz and William Simon all of whom wanted reliance on the market believed that the IMF was ineffective and obsolete and should be abolished Friedman considers the IMFs role in the world economy to exemplify bureau cratic selfaggrandizement The IMF Friedman points out had origi nally been created to supervise the system of fixed exchange rates that was ended by President Nixon in 1971 The IMF then found a new function as an economic consulting agency for countries in trouble offering money in exchange for promises of reforms In Friedmans 272 T H E I N T E R N A T I O N A L F I N A N C I A L S Y S T E M opinion this interventionism by the IMF encouraged countries to continue to pursue unwise and unsustainable economic policies moral hazard Russias failure to take the hard decisions required to salvage its devastated economy he believes was a classic example of IMF encouragement of irresponsible behavior For Friedman and fellow conservatives the IMFs response to the Mexican crisis of 19941995 represented a quantum jump in the IMFs counterproductive interventionism Mexico was bailed out by an aid package of 50 billion put together by the IMF the United States and other countries Friedman has asserted that the IMF money actually ended up in the hands of such foreign entities as American banks that had foolishly lent money to Mexico and that Mexico itself was left in recession and saddled with higher prices However the Mexican crisis had a longer term and even more serious consequence because it fueled the East Asian crisis by encouraging investors to again make risky investments Drawn by high returns and assured that the IMF would bail them out if the exchange rate broke down and governments defaulted investors poured money into the emerg ing markets of East Asia In effect the IMF and its provision of insur ance against currency risk subsidized private banks and investors a clear example of inducing moral hazard that is encouraging undesir able andor counterproductive behaviors This chain of reasoning led Friedman and others to conclude that the solution to financial insta bility must be through elimination of IMFinduced moral hazard The marketoriented position rests on the assumption that investors are rational and will not invest in risky ventures if they know that they will not be bailed out Therefore elimination of moral hazard also eliminates the problem of serious international financial crises Although this conclusion may be correct no such approach has ever been tried and there is no empirical evidence to support such a daring policy experiment Indeed available evidence leads this writer to con clude that investors are not consistently rational that they do get caught up in what Minsky called euphorias and that when the speculative bubble bursts many innocent people get hurt This causes most governments to be unwilling to risk leaving financial matters entirely up to the market indeed many governments have even installed mechanisms at the domestic level to protect their citizens from financial instability Strengthening the IMF Others believe that the solution to the problem of international fi nancial instability can be found in strengthening the regulatory role of the IMF Proponents of this position especially the Clinton Ad 273 C H A P T E R T E N ministration and the IMF believe that liberalization of capital move ments should be a primary purpose of the IMF While agreeing with the market approach about the beneficial nature of unrestricted inter national capital flows they believe that a greater supervisory role by the IMF and other reforms are necessary Indeed the IMF has already taken a number of important initiatives to create a regime for interna tional finance Most importantly the IMF charter has been amended to give it greater jurisdiction over financial matters As IMFs first deputy managing director Stanley Fischer has stated the amendment is intended to enable the Fund to promote the orderly liberalization of capital movements He has also noted however that achievement of this goal requires continuous and reliable information on the fi nancial conditions in potentially risky economies development of an effective surveillance system to monitor such economies and greater authority for the IMF to act as the lender of last resort 7 The following paragraphs discuss some of the major proposed re forms to strengthen the role of the IMF in preventing financial crises Greater Transparency and Improved InformationGathering The 19941995 Mexican crisis was made worse by the poor information about Mexican financial conditions supplied by the Mexican Govern ment to the IMF and investors For example the size of both Mexicos financial reserves and its external debt were kept secret In 1996 les sons learned from this experience did lead to increased IMF data gath ering and dissemination Nevertheless some experts have asserted that even the improved system of data gathering proved inadequate when it did not forestall the 1997 East Asian financial crisis Although more reliable information on the financial conditions of developing econo mies could be an important safeguard against reckless investing gov ernments do wish to keep financial data secret in order to increase their leverage with foreign investors and this raises a major hurdle The predicament is made worse because governments also wish to keep their financial condition secret in order to strengthen their rela tive position in the intensifying competition for capital imports The 1997 East Asian crisis however did strengthen the belief that greater openness about the financial conditions in many countries is required Codes of Conduct and Better Surveillance The IMF has placed much greater emphasis on developing codes of conduct regarding good 7 The purpose of the lender of last resort is to pump money into an economy whose banking system is suffering from a liquidity problem The term liquidity problem is explained below in note 9 274 T H E I N T E R N A T I O N A L F I N A N C I A L S Y S T E M practice in financial affairs in order to increase discipline at the inter national level Among other changes this effort requires upgrading of the Basle Accord 1988 regulating international bank practices 8 In addition improved surveillance and monitoring of specific econo mies for such potential dangers as high budget deficits and high rates of inflation may suggest potential financial troubles However even if a country is warned of impending problems it may not act to fore stall them and the IMF remains powerless to force such action Nor would it be proper for the IMF to warn investors about potential problems in a particular country Lender of Last Resort In a world of increasing capital flows and growing numbers of borrowers it is inevitable that individual coun tries will occasionally experience serious financial troubles and re quire international assistance in the form of a large infusion of money to prevent a liquidity or even an insolvency problem 9 Many believe that the IMF should perform the role of lender of last resort however the IMF is seriously limited in this capacity because unlike a true central bank the IMF cannot create money also its cumbersome governing mechanism prevents it from acting quickly in a crisis In addition assumption of the lenderoflastresort role raises the prob lem that the larger the IMFs resources the greater the risk that it will encourage moral hazard Strengthening the IMF in order to promote freedom of capital movements and prevent financial crises has been an important objec tive of the United States American commitment to promarket ideol ogy powerful financial interests to which the US Treasury is highly responsive and a general belief that America has a strong compara tive advantage in financial services have been reflected in US efforts to keep economies open to international finance However the con troversy in 1998 over Americas 18 billion contribution to the IMF illustrates that the Clinton Administrations effort backed by export 8 Basle refers to the International Bank for Settlements in Basle Switzerland which sets standards for international banks The Basle Accord of 15 July 1988 estab lished international harmonization of regulations regarding the capital adequacy or reserve requirements of international banks The agreement was the result of an Ameri can initiative in response to American banking interests American proponents of the agreement believed that foreign banks had an unfair advantage because of their rela tively low reserves requirements Despite strong opposition from other countries American pressure for the accord eventually won 9 A liquidity crisis exists when an otherwise sound economy has a temporary cash flow problem An insolvency crisis exists when an economy has severe economic problems and cannot repay its debts without making major economic reforms 275 C H A P T E R T E N interests to strengthen the IMFs role in preventing financial crises had many opponents that Congressional and public controversy raised serious questions about the ability of the United States to lead in fashioning a new international financial architecture Regulation of International Finance A number of economists and governments favor some controls over international capital movements Agreement that shortterm capital flows should be regulated appears strong James Tobin and other American economists for example have proposed a tax on short term capital flows and Paul Krugman has argued that countries in financial difficulty should consider capital controls The French Ger man and Japanese governments have raised the possibility of other measures to tame large swings in global financial markets and in cur rency values They have also proposed that the European Union Ja pan and the United States should manage exchange rates and keep them within specific bands or target zones in order to stabilize the global economy However the United States has strongly objected to delegating decisions over interest rates and other aspects of its own economy to any international authority it prefers to rely on the market The differences between the United States and its principal eco nomic partners over currency and financial matters were the subject of the annual meeting of the G7 finance ministers and central bank ers in February 1999 where creation of a mechanism to regulate in ternational finance was the principal issue discussed On one side of the debate were the German French and Japanese governments fa voring increased controls many European and Japanese officials wanted to control hedge funds in particular On the other side were the United States and US and other central bankers who strongly opposed an international authority and preferred to leave matters to national governments and central bankers The differences between the United States and the other economic powers partially reflect ideological positions on market functioning but they also reflect the relative competitiveness of American financial institutions as well as their political strength within the United States Eventually agree ment was reached that a financial stability forum composed of na tional currency regulators meeting twice a year to consult and con sider ways to improve the quality of financial information would be created The difficulties experienced by the G7 in efforts to agree on reforms of international financial affairs do not augur well for the future stability of the global economy 276 T H E I N T E R N A T I O N A L F I N A N C I A L S Y S T E M The underlying motive of the West Europeans and the Japanese in their advocacy of greater controls over international finance is at least in part political The West Europeans would very much like to diminish the American role in international monetary and financial matters in order to minimize the potential negative impact of Ameri can policies on Europe The European Union would like to restrict the independence of American macroeconomic policy Japan has en couraged greater use of the yen in international transactions and would like to distance the AsiaPacific region from the international use of the dollar Conclusion Freeing capital and integrating financial markets around the world have had several important consequences for the global economy Freedom of capital movements has complicated and some believe reduced macroeconomic policy autonomy and the ability of individ ual governments to control their own economies 10 International fi nancial flows have also become an important determinant and many economists believe they are the most important determinant of ex change rates at least in the short term and a cause of erratic move ments in currency values Movement toward a single globally inte grated market for corporation ownership has resulted from increased financial flows and this has greatly facilitated corporate mergers and takeovers across national boundaries and the integration of the world economy by multinational firms Altogether the reemergence of inter national finance has increased interdependence of trade monetary and other aspects of the international economy The need to mesh these formerly separate domains of international economic affairs has complicated the task of managing the world economy 10 A dramatic example of how international financial flows have constrained domes tic economic policy was the disastrous attempt of the French socialist government of Francois Mitterrand in the early 1980s to stimulate the laggard French economy Capi tal flight forced the French government to rein in its expansionary economic policies This instructive episode is analyzed from quite different perspectives by Michael Lori aux France After Hegemony International Change and Financial Reform Ithaca Cor nell University Press 1991 and Paulette Kurzer Business and Banking Political Change and Economic Integration in Western Europe Ithaca Cornell University Press 1993 277 CHAPTER ELEVEN The State and the Multinationals T HE IMPORTANCE of the multinational corporation MNC is a key feature of globalization of the world economy 1 However opinions differ greatly over the significance for domestic and interna tional economic affairs of the globalization of corporate activities Some commentators believe that the multinational corporation has broken free from its home economy and has become a powerful inde pendent force determining both international economic and political affairs Others reject this position and believe that the multinational corporation remains a creature of its home economy Although there are many more technical definitions of a multina tional firm this chapter refers simply to a firm of a particular nation ality with partially or wholly owned subsidiaries within at least one other national economy Tens of thousands of MNCs with numerous subsidiaries conduct business around the world Such firms expand overseas primarily through foreign direct investment FDI whose purpose is to achieve partial or complete control over marketing pro duction or other facilities in another economy such investments may be in services manufacturing or commodities FDI can entail either the purchase of existing businesses or the building of new facilities called greenfield investment Overseas expansion is frequently ac companied by mergers takeovers or intercorporate alliances with firms of other nationalities 2 Whereas the purpose of portfolio invest ment is to obtain a financial return on the investment FDI as well as alliances mergers and similar ventures are usually part of an in ternational corporate strategy to establish a permanent position in another economy In one sense multinational firms have existed for a very long time The Dutch East India Company the Massachusetts Bay Company and other companies of merchantadventurers were forerunners of todays MNCs like IBM Sony and DaimlerChrysler These earlier 1 Sylvia Ostry A New Regime for Foreign Direct Investment Washington DC Group of Thirty 1997 5 2 Benjamin GomesCasseres The Alliance Revolution The New Shape of Business Rivalry Cambridge Harvard University Press 1996 278 T H E S T A T E A N D T H E M U L T I N A T I O N A L S transnational firms however were far more powerful than contem porary MNCs are they commanded armies and fleets had their own foreign policies and controlled vast expanses of territory the sub Asian continent India Pakistan and Bangladesh the East Indies In donesia and South Africa Modern MNCs are much more modest Another major difference between those early transnational firms and todays is that the former were principally interested in agricultural products and extractive industries in particular regions of the world whereas major firms in the early twentyfirst century are principally involved in manufacturing retailing and services tend to operate on a regional or worldwide basis and usually pursue an international corporate strategy It is particularly significant that whereas the ear lier firms frequently exploited and subjugated native peoples todays MNCs with some exceptions are important sources of the capital and technology required for economic development of the less devel oped countries Explanations of FDI and the MNC Despite the importance of multinational corporations in the function ing of the international economy neoclassical economists have re markably little to say about them The indifference of mainstream economists to the MNC means that the student of the MNC must turn for an understanding of these firms to the writings of radical economists business economists and political economistsgroups of scholars with a longterm interest in multinational firms and their impact Mainstream Economists and the MNC The indifference of most neoclassical economists to the multinational corporation despite its importance in the global economy can be ex plained in various ways 3 Their strong belief in the primacy of mar kets causes those economists to discount the importance of institu tions they believe that a firms behavior is determined almost entirely by market signals and that therefore the nationality of the firm and whether it is operating domestically or internationally are of slight importance Furthermore the Mundell equivalency accepted by most economists holds that international transfer of the factors of produc 3 A survey of the economics literature on the subject can be found in Gene M Gross man ed Imperfect Competition and International Trade Cambridge MIT Press 1994 910 279 C H A P T E R E L E V E N tion capital technology etc through foreign direct investment FDI produces consequences for the realworld equivalent to those from the international flow of goods In other words from the economists perspective trade and investment are perfect substitutes for one an other Economics also teaches that trade precedes investment rather than vice versa The location of economic activities around the world and patterns of trade are determined by the theory of location and the principle of comparative advantage production will be located where it is most efficient An economist might argue that FDI is an indirect route to economic specialization based on the distribution of productive factors Also methodological obstacles have prevented economists from formulating a generally accepted theory to explain FDI and the MNC MNCs are primarily oligopolistic firms and function in imperfect markets and as has already been noted there is no satisfactory for mal model to account for all types of oligopolistic behavior Lack of a general model encourages ambiguous and contradictory attitudes among economists toward multinational firms A major reason why neoclassical economics has been unable to provide a general theoreti cal explanation for the MNC and FDI is that the MNC is largely a product of market imperfections and unique corporate experiences For example IBM manufactures in a number of countries so as to maintain good political relations with host governments rather than for strictly economic reasons Some market imperfections are created by national governments through such policies as trade protection and industrial policy in fact a government sometimes creates market imperfections to encourage foreign MNCs to invest in their econo mies A notable example is the erection of trade barriers and the pro vision of tax breaks to encourage FDI Without such imperfections a firm might find it more efficient to export its products from its home economy or to license its technology to a foreign firm The ambiguous attitude of professional economists toward the MNC is illustrated in Paul Krugmans writings On the one hand he has taken the conventional position that MNCs are not a significant factor in the international economy indeed he and coauthor Maurice Obstfeld have written in their textbook on international economics 1994 that the effects of FDI on global distribution of economic ac tivities and other economic outcomes cannot be distinguished from those of international trade 4 The principal effect of FDI they argue 4 Paul R Krugman and Maurice Obstfeld International Economics Theory and Practice 3d ed New York HarperCollins 1994 162 280 T H E S T A T E A N D T H E M U L T I N A T I O N A L S is on the domestic distribution of income that is between capital and labor On the other hand Krugman argues in many of his other writ ings that the oligopolistic nature of international business is signifi cant for trade patterns and the location of economic activities For example because oligopolistic firms engage in strategic behavior an MNCs decision whether to export a product from its home market or to invest abroad in order to service a foreign market will strongly affect the location of economic activities and the rates of economic growth around the world In this fashion the activities of MNCs can have a profound impact on international economic affairs MNCs are not merely substitutes for trade indeed they attempt to extend their power and control over foreign economies It is clear that multina tional firms desire not only to earn immediate profits but also to change and influence the rules or regimes governing trade and inter national competition in order to improve their longterm position Fortunately the traditional indifference of economists to MNCS has begun to change in response to a number of theoretical develop ments as well as the undeniable importance of the MNC in the world economy Theoretical advances in industrial organization and strate gic trade theory as well as growing appreciation of the significance of technological innovation for comparative advantage have made economists more aware of MNC importance For example the MNC has been acknowledged as a means to reduce transaction costs it may be cheaper to organize vertically through FDI than by market transactions The research of Harvard economist Richard Caves has stressed the importance of appropriability that is of a firms abil ity to maintain control of a valuable asset such as a trademark or technology 5 Nevertheless even though mainstream economists have become somewhat more sympathetic to the idea that MNCs do be have differently from nonMNCs and have a particularly important role in the world economy a cursory examination of current econom ics syllabi and textbooks confirms that economists do not yet consider the MNC an important aspect of the world economy Business Economists and the MNC Business economists have long had a strong interest in the wellsprings of corporate behavior an interest strongly influenced by the pioneer ing scholarship of Alfred Chandler 6 Beginning in the 1960s interest 5 Richard E Caves Multinational Enterprises and Economic Analysis Cambridge Harvard University Press 1982 6 Alfred D Chandler Strategy and Structure Chapters in the History of the Indus trial Enterprise Cambridge MIT Press 1970 281 C H A P T E R E L E V E N in corporations has been extended to firms operating internationally Research on the MNC has been pursued almost exclusively by Ameri can and British business economists with a liberal commitment to ward the overwhelming benefits of FDI to both home and host coun tries Scholarship on this matter has been overwhelmingly empirical and has seldom been informed by economic or other types of social theory Because this writer cannot do justice to the huge volume of writings that have paralleled and interpreted the several stages in the development of the MNC I shall focus on just a few important con tributions to illustrate the essence and evolution of this scholarship An early important contribution was the influential pioneering work of Raymond Vernon Vernons product cycle model of FDI stressed the importance of economic and technological leadership and provided an important insight into the overseas expansion of Ameri can MNCs in the 1960s Another valuable contribution to the subject was made by British business economist John Dunning who along with others attempted to provide a general explanation of the MNC the result was the eclectic theory of FDI that accounted in large part for the second stage of the MNCs evolution The most recent expla nation is generally identified with Michael Porters extensive and al most encyclopedic empirical research on the firm as a strategic player in the game of international economic competition Vernons Product Cycle Theory The crux of Vernons product cycle theory as set forth in Sovereignty at Bay 1971 was that every prod uct follows a life cycle from innovation through maturity to decline to eventual obsolescence 7 American firms Vernon argued had a comparative advantage in product innovation due to the huge size of the American market the demand side and to American superiority in research and development the supply side During the initial phase of the product cycle firms export new products from their home industrial base but in time a number of changes associated with the maturing of the product such as standardization of produc tion techniques diffusion abroad of industrial knowhow and cre ation of significant foreign demand for the product stimulate the en try of foreign imitators into the market To deter foreign firms from entering the market and undercutting their monopoly position the original firms establish production facilities in other economies Thus according to Vernons product cycle theory foreign direct investment 7 Raymond Vernon Sovereignty at Bay New York Basic Books 1971 282 T H E S T A T E A N D T H E M U L T I N A T I O N A L S is principally a device used by firms to preempt foreign competition and to maintain their monopoly rents Vernons theory which assumed that there were large gaps in wealth and technology between the United States and other countries helped to explain the overseas expansion of American firms in the 1960s As such gaps disappeared in the 1970s the relevance of his theory to the behavior of American firms declined Furthermore product cycle theory could not account for the subsequent expansion abroad of European and Japanese firms and the firms of many other nations Other business economists explanations of these new devel opments include such specific and general factors as the erection of trade barriers the importance of market proximity the decline in transportation costs and the problem of currency fluctuation The eclectic theory primarily associated with John Dunning and the Reading school was the most systematic effort to incorporate the many developments during this second stage in MNC evolution into a coherent general explanation of the MNC and FDI 8 Dunnings and the Reading Schools Eclectic Theory The eclectic the ory of the MNC developed by John Dunning and the Reading School named after the University of Reading England provides important insights into the MNC as it emphasizes technology as a factor in MNC development Revolutionary advances in communications and transportation have made it technically possible for businesses to or ganize and manage services and production systems on a global basis In effect technological advances have greatly reduced the transaction and other costs of internationalizing However the eclectic theory is hardly a theory at all at least not a theory that mainstream econo mists would acknowledge rather it is a collection of ideas gathered from many sources and much research on the MNC Dunning and his Reading colleagues believe these ideas provide a comprehensive understanding of the MNC While Dunnings integration of various ideas and insights into the nature and behavior of the MNC is gener ally nontheoretical it is nevertheless quite valuable However the usefulness of the eclectic theory is most relevant for understanding a particular stage in the evolution of the MNC subsequent changes in the MNC have necessitated newer explanations for their behavior 8 The writings of John N Dunning on the MNC are voluminous One place to start is Dunning Explaining International Production London Unwin Hyman 1988 In addition to Dunning other members of the Reading School include Peter J Buckley and Mark C Casson 283 C H A P T E R E L E V E N Work by Michael Porter and others builds on and incorporates the core of Dunnings eclectic explanation According to Dunnings eclectic theory the unique nature and ex traordinary economic success of the MNC are due to particular char acteristics that give the MNC important advantages over purely do mestic corporations These advantages are ownership location and most importantly internalization a concept that was also extensively developed by Richard Caves one of few mainstream economists to seriously consider FDI and the MNC 9 These oligopolistic firms usu ally possess some proprietary or firmspecific advantage that they want to exploit rather than lose to a rival firm such an internal ad vantage may be a trademark or possession of a particular technology Although some of the most important MNCs are not hightech it is not coincidental that many MNCs predominate in industries charac terized by extensive and expensive research and development activi ties Obviously such firms are anxious to appropriate for themselves all the results of their R D efforts As Caves has pointed out FDIs advantages in ownership and inter nalization explain why firms are willing to assume its high costs and risks Although in most cases it would be far more efficient to export from existing plants in the home economy than through production abroad Caves argues that maintaining within their own control such monopolistic advantages as a trademark or knowhow gives firms market power and the ability to extract rents This internalization objective can best be achieved through FDI and the creation in other economies of subsidiaries that are owned by the parent firm Oligopo listic firms attempt to keep firmspecific advantages within the secure confines of the firm and out of the hands of rival firms through the establishment of greenfield plants or the acquisition of wholly owned foreign subsidiaries over which they have exclusive control Many such firms also possess locational advantages because MNCs have access to factors of production around the world and can therefore employ such countryspecific advantages as access to lowcost skilled labor or to other special local resources Considered in terms of the HeckscherOhlin model of international trade these firms can exploit the comparative advantages possessed by other economies and such flexibility can give them a considerable advan tage over purely domestic firms Moreover even though the firms home economy may be losing comparative advantage in its particular industrial sector the MNC itself can maintain its presence in the in 9 Caves Multinational Enterprises and Economic Analysis 284 T H E S T A T E A N D T H E M U L T I N A T I O N A L S dustry through FDI in economies gaining comparative advantage within that industry Other factors have been important to the success of the MNC in cluding deregulation of markets and services around the world Cer tainly deregulation and integration of financial markets have facili tated foreign direct investment The continuing shift in comparative advantage in many traditional and other industrial sectors to low wage industrializing economies has also been a factor determining MNC strategy And particularly among Japanese firms a desire to leap over trade barriers and to reduce growing trade friction has also contributed to FDI expansion Yet another relatively important con sideration has been the corporate ideology spread by numerous busi ness consultants and other prophets of the global corporation that firms must learn to manage across borders and become truly global if they are to survive in the new global economy Porters Strategic Theory Another noteworthy interpretation of the MNC has emerged from the research of Michael Porter at the Har vard School of Business Porters Competitive Advantage of Nations 1990 and his numerous other writings argue that the MNC has entered an era of strategic management 10 Porter assumes that interna tional business is characterized by a value chain of activities rang ing from extraction to production to marketing The individual firm must decide which and how many of these activities it wishes to pur sue and in what locations around the globe These decisions in turn depend on the overall competitive strategy of the firm Following the lead of Alfred Chandler in his classic contributions to business stud ies 11 Porter argues that the firms strategy determines its structure and its location of economic activities throughout the world economy In the development of his theory of strategic management Porter fol lows the eclectic theorys definition of the inherent advantages pos sessed by MNCs But the overwhelming advantage of the MNC over domestic firms according to Porter is that it provides access to a wide array of possible strategies through which it can tap into the value chain In contrast to a domestic firm a multinational firm can carry out its activities at the most efficient location for each particular activity anywhere in the world Because the firm pursues its strategy and integrates its activities across national borders many analysts 10 The references to Porter in this chapter are based on Michael E Porter The Com petitive Advantage of Nations New York Free Press 1990 11 Chandler Strategy and Structure 285 C H A P T E R E L E V E N prefer to use the term transnational rather than multinational corporation The essence of strategic management is that the transnational firm has available to it more extensive options and techniques than do even the largest domestic firms These mechanisms include not only FDI but also strategic alliances outsourcing component production and licensing technologies These corporate activities create interna tional complexes or networks of corporate relations with the parent MNC in its home economy Through modern information technolo gies and monopoly of information resources the multinational corpo ration can become dominant over both its domestic and international competitors Needless to say such a depiction of a firms strategy structure and activities has evolved far beyond that portrayed in Ver nons product cycle model or even in Dunnings eclectic theory These transnational firms have become worldwide institutions coordinating economic activities that are located in many countries Political Economists and the MNC There are two distinctive bodies of writings by political economists on the multinational corporation the radical or quasiMarxist cri tique and the statecentric interpretation Marxist or Radical Theories Stephen Hymers innovative ideas pre sent the most systematic critique of the MNC 12 Hymer trained as a technical economist at the mecca of neoclassical economics the De partment of Economics at the Massachusetts Institute of Technology has contributed to the subject both as an economist and a radical political thinker but I am primarily concerned with his latter work At the time of Hymers writings in the early 1960s economists scarcely distinguished between foreign direct investment and foreign portfolio investment Instead they assumed that FDI like portfolio investment could be explained primarily by differences in interest rates between home and host economies Hymer showed on the other hand that FDI was fundamentally different from portfolio investment and could be explained as part of a firms expansionist strategy and by its desire to control productive or other facilities in foreign coun tries Economic political and technological developments in the post 12 Stephen Hymer first set forth his ideas in his 1960 doctoral dissertation The International Operations of National Firms A Study of Direct Investment which was not published until 1976 by the MIT Press 286 T H E S T A T E A N D T H E M U L T I N A T I O N A L S war world had made overseas expansion of American corporations possible and even necessary At the time of Hymers writings Ameri can corporations were rapidly expanding in the Western Hemisphere the Middle East and Western Europe Anticipating both the subse quent application of industrial organization theory to the study of the MNC and the eclectic theory Hymer argued that American firms invested abroad to exploit and preserve some firmspecific or monop olistic advantage Despite the potential importance of Hymers scholarship it made little impression on the economics profession Unfortunately Hym ers death at a young age meant that he had no opportunity to de velop and defend his ideas Hymers ideas were neglected at least in part because his innovative thinking was too far ahead of the rest of the economics profession Only years later did insights from indus trial organization theory vindicate at least some aspects of his think ing Another possible reason however for economists neglect of Hymers theories is that Hymer was a Marxist and although econo mists deny that his Marxism posed a problem I find this denial diffi cult to accept Whatever the truth of the matter it is the Marxist aspect of Hymers innovative approach that is of interest at the mo ment In his Marxist or quasiMarxist theory of the MNC Hymer set forth or at least foreshadowed many if not most of the ideas that we now associate with radical critiques of the MNC He believed that monopoly capitalism is driven by two fundamental laws He believed the first law of international capitalism to be the law of increasing firm size that as firms grow in size and scope they expand both within and across national borders creating a hierarchical corepe riphery structure and international division of labor around the world At the core of this international structure are the advanced capitalist economies while the periphery is composed of dependent and exploited less developed economies Hymers second law is the law of uneven development He argued that due to their large size considerable mobility and monopolistic power the MNCs exercise control over and exploit the whole world to their own advantage These corporate activities produce a world economy composed of the exploiting wealthy societies of the north and the exploited impoverished societies of the south Or in language also used by dependency theorists the development of the capitalist north and the underdevelopment of the peripheral south are integral and complementary aspects of international capitalism in the age of 287 C H A P T E R E L E V E N the MNC 13 Almost all the subsequent writings by radical scholars are in large part just variations on Hymers provocative ideas 14 This generalization also applies to many of those protesting the multina tional corporation at the time of the WTO meetings in Seattle in 1999 and the IMFWorld Bank meetings in Washington in 2000 even though the protestors doubtless were unaware of Hymers theories Statecentric Interpretation Statecentric writings on the multina tional corporation assert that the rise and success of the MNC in the modern world could have happened only within a favorable interna tional political environment They maintain that despite the several theories of business economists the MNC cannot be explained solely in terms of market forces andor corporate strategies 15 While eco nomic factors are obviously important for the emergence and success of MNCs they could not exist without a favorable international po litical environment created by a dominant power whose economic and security interests favor an open and liberal international econ omy Just as the Pax Britannica provided a favorable international environment for the overseas expansion of British firms and investors in the late nineteenth century so American leadership following World War II provided a similarly favorable international environ ment for the overseas expansion of American and other capitalist firms in the postWorld War II era In the 1980s and 1990s the United States Western Europe and Japan all had an interest in main taining and even strengthening international conditions that favored MNCs Statecentric writers believe that if the consensus and coop eration of the major capitalist powers were to break down the pre dominant role of the MNC in the world economy would gradually diminish The statecentric position also assumes that multinational firms are essentially national firms competing with one another around the world Proponents of this position argue that these firms are closely attached to and ultimately dependent on their respective home econo mies As Paul Doremus and his colleagues point out in their excellent book The Myth of the Global Corporation 1998 each MNC is a 13 Among the more innovative and influential extensions of Hymers early work is Robert Cox Production Power and World Order Social Forces in the Making of History New York Columbia University Press 1987 14 For example see William Greider One World Ready or Not The Manic Logic of Global Capitalism New York Simon and Schuster 1997 15 This is the thesis of my book US Power and the Multinational Corporation The Political Economy of Foreign Direct Investment New York Basic Books 1975 288 T H E S T A T E A N D T H E M U L T I N A T I O N A L S distinctive product of its home base and reflects its social economic and political values 16 Despite the hyperbole of corporate executives and business consultants that MNCs have shorn themselves of na tional coloration and become stateless enterprises MNCs are actually deeply embedded in and very much a product of the history culture and economic systems of their home societies The Multinationals and the International Economy The worlds largest MNCs account for approximately fourfifths of world industrial output while typically employing twothirds of their work force at home they are not nearly as footloose as many critics charge 17 Foreign direct investment FDI has been growing at a rapid rate Between 1985 and 1990 FDI grew at an average rate of 30 percent a year an amount four times the growth of world output and three times the growth rate of trade FDI has in fact become a major determinant of trade patterns The annual flow of FDI has doubled since 1992 to nearly 350 billion Intrafirm tradethat is trade among subsidiaries of the same firmaccounted for onethird of American exports and twofifths of US imported goods in 1994 About onehalf of the trade between Japan and the United States is actually intrafirm trade This intrafirm trade takes place at transfer prices set by the firms themselves and within a global corporate strat egy that does not necessarily conform to the conventional trade the ory based on traditional concepts of comparative advantage Evidence suggests that these trends will continue and could even accelerate The gross statistics however hide noteworthy aspects of FDI and of other activities of MNCs Despite much talk of corporate global ization FDI is actually highly concentrated and is distributed un evenly around the world Although FDI has grown rapidly in devel oping countries most FDI has been placed in the United States and Europe while only a small percentage of US foreign direct invest ment has gone to developing countries This concentration of FDI is due to the simple fact that the United States and Europe are at present the worlds largest markets Nevertheless throughout most of the 1990s FDI in less developed countries LDCs grew at about 15 percent annually However FDI in LDCs has been highly uneven and concentrated in a small number of countries including a few in 16 Paul N Doremus William W Keller Louis W Pauly and Simon Reich The Myth of the Global Corporation Princeton Princeton University Press 1998 17 The Economist 29 January 2000 21 289 C H A P T E R E L E V E N Latin America especially Brazil and Mexico and in the emerging markets of East and Southeast Asia The largest LDC recipient of FDI has been China Between 1991 and 1995 foreign direct invest ment placed in the United States amounted to 1985 billion in China 1143 billion and in Mexico only 32 billion The emerging markets were attractive at least prior to the 1997 financial crisis due to their rapid economic growth their marketoriented policies and their cheap labor One should note however that the least developed countries in Africa and elsewhere have received a pitifully small per centage of the total amount invested in the developing world Need it be said that this skewed distribution does not fit the image of glob alization The increasing importance of MNCs has profoundly altered the structure and functioning of the global economy These giant firms and their global strategies have become major determinants of trade flows and of the location of industries and other economic activities Most FDI is in capital and technologyintensive sectors These firms have become central in the expansion of technology flows to both industrialized and industrializing economies and therefore are impor tant in determining the economic political and social welfare of many nations Controlling much of the worlds investment capital technology and access to global markets such firms have become major players not only in international economic but in international political affairs as well and this has triggered a backlash in many countries According to DeAnne Julius one of the worlds most knowledge able experts on the MNC the huge expansion of FDI intercorporate alliances and intrafirm trade throughout the 1980s and 1990s reached a level where a qualitatively different set of linkages among advanced economies was created some have estimated that more than twenty thousand corporate alliances were formed in the years 19961998 18 The growing importance of FDI and intercorporate co operation means that the world economy has reached a takeoff point comparable to that wrought by the great expansion of interna tional trade in the late 1940s and the subsequent emergence of the highly interdependent international trading system The growth in FDI and in the activities of multinational corporations of many na tionalities has linked nations more tightly to one another and this has further affected the global economy 18 DeAnne Julius Global Companies and Public Policy The Growing Challenge of Foreign Direct Investment London Pinter 1990 290 T H E S T A T E A N D T H E M U L T I N A T I O N A L S The role of MNCs in the world economy remains highly controver sial Critics charge that foreign direct investment and the internation alization of production are transforming the nature of international economic and political affairs in ways that undermine the nation state and integrate national economies Impersonal market forces and corporate strategies are believed to dominate the nature and dynamics of the international economic and political system While Kenichi Oh mae and many others may believe such a development to be highly beneficial for mankind others regard the MNC as an exploitative imperium stalking the world These critics believe that giant firms answerable only to themselves are integrating societies into an amor phous mass in which individuals and groups lose control over their own lives and are subjugated to firms exploitative activities The world these critics charge is coming under the sway of a ruthless capitalist imperialism where the only concern is the bottom line Many and perhaps most professional economists with the impor tant exception of business economists on the other hand discount the significance of multinational firms in the functioning of the world economy The neoclassical interpretation acknowledges that large oli gopolistic firms may be politically important and may also affect the distribution of income within national economies However these economists deny that the investment marketing and other economic activities of these firms around the world have any great impact on the real economy of international trade location of economic ac tivities or national rates of economic or productivity growth In neo classical economics the global location of economic activities and patterns of international trade are determined according to location theory and the principle of comparative advantage Both extreme positions are exaggerations Critics exaggerate the evils of the MNCs and their role in the world economy Although some MNCs do exploit and damage the world the MNC as an insti tution is beneficial to many peoples worldwide it is for example a major source of capital and technology for economic development On the other hand the proponents of the MNCs exaggerate their importance and overstate the internationalization of services and pro duction The nationstate remains the predominant actor in interna tional economic affairs and domestic economies are still the most important feature of the world economy Although some convergence has been occurring national societies retain their essential character istics and are not becoming part of any homogenized amorphous mass In an era of oligopolistic competition and rapid technological innovation location theory and the conventional theory of compara 291 C H A P T E R E L E V E N tive advantage cannot tell the whole story of what is happening in the world economy Multinational firms and their investment activi ties are important parts of the explanation Increased Regionalization of Services and Manufacturing One of the most important recent developments in the world econ omy has been the internationalization of services and of industrial production a development facilitated by falling costs for communica tion and transportation that have enabled firms to integrate produc tion and other activities around the globe Continuing restructuring of services and manufacturing was extremely important in the nature of the world economy as it entered the new millennium Nevertheless the importance of this development is frequently misunderstood and exaggerated Whereas FDI in the year 2000 is only a small part of the total domestic investment of the rich countries in the decade prior to 1914 British capitalists invested almost as much abroad as at home and the European stock of FDI was higher in 1914 than it is relatively in the twentyfirst century Furthermore contrary to the oft stated opinion that MNCs have globalized technology and put their own firms everywhere on an equal footing nothing could be farther from the truth For reasons internal to the firms themselves and because of conditions prevailing in many developing countries technology tends to diffuse from industrialized to industrializing countries relatively slowly 19 Moreover internationalization of services and production is highly concentrated among the major powers and within particular regions one estimate made in the mid1990s was that 85 percent of all foreign investment takes place among the members of the Triad United States Western Europe and Japan 20 The multinational firms of the three major economic powers have been concentrating their FDI in their respective backyards and fashioning regionalized production and service networks American FDI has been shifting away from East and Southeast Asia toward Mexico Whereas American firms relied previously on East and Southeast Asia as sources for components outsourcing has recently been shifting toward Mexico although be 19 This is the conclusion of Keith Pavitt in summarizing the pathbreaking work on technology policy and innovation carried out at the University of Sussexs Science Pol icy Research Unit 20 Robert Boyer and Daniel Drache States Against Markets The Limits of Globaliza tion New York Routledge 1996 2 292 T H E S T A T E A N D T H E M U L T I N A T I O N A L S cause of Chinas very low wage labor and vast potential as a market China has been an exception to this trend Japanese firms prefer East Asian subcontractors and most of their manufactured imports have come from this region Germany for economic and political reasons and to take advantage of East Europes highly skilled and lowercost labor has been investing heavily in Eastern Europe especially Poland the Czech Republic and Hungary Evidence thus suggests that region alism as well as globalism characterizes the strategies of multinational firms While economic competition and financial markets have be come increasingly global production and services are increasingly re gional 21 The trend toward regionalization of investment services and pro duction can be explained in several ways New methods of produc tion and management such as lean production and flexible manu facturing encourage regionalization both techniques require highly trained and motivated workforces that can be utilized more fully and with less risk at the regional than at the global level Indeed the need to move to lowwage areas has been greatly reduced as the share of unskilled labor in production has fallen dramatically since the 1970s Regional concentration also facilitates scale economies in production Another consideration is that regional production networks enable firms to be closer to their principal customers this factor will become even more important as regional markets continue to develop in Western Europe and North America Cultural affinities may also play a part in this trend Furthermore regionalization of production can insulate economies throughout the region from trade wars and cur rency fluctuations For these and other reasons the movement toward regionalization of production will continue within North America Pacific Asia and Western Europe and is likely to strengthen in Latin America and elsewhere The increased importance of regionalization in the world economy raises some disturbing possibilities The trend toward regionalization could lead to weakening of the postWorld War II movement toward trade liberalization While the MNCs of the major economic powers continue to pursue global strategies and to invest in one anothers economies with the exception caused by Japans relatively low level of inward FDI they are also concentrating their own FDI in neigh boring countries Creation of regional rather than global production and sourcing networks has become a notable trend If the movement 21 Charles Oman Globalization and Regionalization The Challenges for Developing Countries Paris Development Centre of the OECD 1994 293 C H A P T E R E L E V E N toward globalization should be slowed by increased regionalization of services and production the open global economy could suffer a setback this would have serious negative consequences for countries that were not members of a regional arrangement And in the year 2000 most less developed economies lie outside the emerging re gional blocs Debate over the MNC and the NationState There are divergent views of the MNCs role in the world economy and of their relationship to their home economies On the one hand are some who believe that the MNCs increasing importance in the organization and management of the international economy consti tutes a transformation of global economic and political affairs For them globalization of production and the central role of the multina tional firm in the world economy represent the triumph of market forces and economic rationality over the anachronistic nationstate and a politically fragmented international economy On the other hand the statecentric position argues that the extent and impact of globalization are greatly overstated and that the nationstate contin ues to set the rules that MNCs must follow In this debate the impor tance of multinational corporations is really not at issue and few observers other than economists deny their significance Powerful cor porations their farflung subsidiaries and their global alliances as John Stopford and Susan Strange have demonstrated in their book Rival States Rival Firms 1991 have for more than a decade been recognized as major features of contemporary international affairs 22 However arguments continue regarding the extent to which these corporate giants have affected the nature and organization of the in ternational economy and the relative significance of the nationstate in its functioning MNCs have certainly introduced changes in the global economy As firms have increased their presence in foreign markets some dis tancing from their home economies has taken place and their national identities have been attenuated yet the greater part of a firms pro duction R D and activity remains in the home economy It is also true that the huge expansion of intrafirm trade has changed the mean ing of imports and exports If for example the overseas sales of 22 John M Stopford and Susan Strange with John S Henley Rival States Rival Firms Competition for World Market Shares New York Cambridge University Press 1991 294 T H E S T A T E A N D T H E M U L T I N A T I O N A L S American subsidiaries are taken into account then the United States has had a large trade surplus for many years The increased interna tional mobility of firms has encouraged national governments to pur sue aggressive policies to attract FDI The Global Firms and the Borderless Global Economy Kenichi Ohmae the Japanese business consultant is a strong propo nent of the thesis that the MNC has become a powerful independent actor rivaling and even outstripping the nationstate in importance In his book The Borderless World he argues that the global ie stateless firm is a natural response to a borderless world economy characterized by homogeneous consumer tastes 23 The ongoing pro cess of economic globalization Ohmae contends has transformed the very nature of the multinational corporation itself In his view the early multinational corporation treated foreign operations as append ages used to manufacture products that had been designed and engi neered back home in such a situation the chain of command and the nationality of the firm were clear However Ohmae is convinced that the nature of the firm has changed drastically due to extensive out sourcing and integration of production and other corporate activities on a global basis The transnational firms of the 1990s he believes have become truly global corporations that are stateless and indepen dent of their national origins Corporate planning for example is now more and more likely to be conceived in global rather than na tional terms Even ownership itself has become unclear as equity sharing joint ventures and corporate alliances unite firms across national borders Ohmae and many others argue that the worlds cor porations are shedding their national identities and becoming true citizens of the world as they make their production and other deci sions without special reference to their home country Those who agree with Ohmae maintain that alliances and linkages among global corporations across national boundaries have led to the home economys loss of significance in the competitive success of the firm Instead Ohmae argues the most important firms must have a strong base in all three members of the TriadNorth America West ern Europe and Japan Firms need foreign partners to obtain market access or to share the increasing costs of research and product devel opment The increasing importance of scale economies and the esca lating costs of R D as well as the rapid pace scope and cost of 23 Kenichi Ohmae The Borderless World Power and Strategy in the Interlinked Economy New York HarperBusiness 1990 295 C H A P T E R E L E V E N modern technology all encourage the growth of corporate alliances within and across national borders Ohmae and others argue that international corporate alliances have undermined the significance of national boundaries and created trans national links that override national political differences Although corporate alliances can be identified in all industries they are espe cially important in such hightech sectors as aerospace electronics and automobiles which are characterized by costly researchandde velopment activities large economies of scale and a high risk of fail ure The rapid pace of technological change the huge costs involved in technological innovation and protectionist regional arrangements mean that even the largest firms need foreign partners with which they can share technology and other resources as well as gain access to protected markets According to this formulation there is interna tional competition between industrial complexes composed of major corporations rather than between individual firms and therefore a firms international standing depends on the relationships that it has been able to establish with other firms The process of economic globalization according to this position has several important consequences for the overall world economy Some allege that within the Triad itself there is a trend toward eco nomic convergence many believe that the production financial and technological structures of the leading economies are following a common pattern Also the ups and downs of Triad economies are viewed as synchronous moving together through business cycles and having common economic policies Growing trade investment and technology flows within the Triad have drawn the major economies closer together and the global firm has become both a cause of and a response to the increasing integration of the world economy The global economy populated by these firms has been described by former Clinton Administration Labor Secretary Robert Reich as a seamless web in which there no longer are any purely national econo mies corporations or products 24 In a world where components may be made in several countries assembled in another and sold in yet a third the nationality of a particular firm or good has become almost impossible to identify and moreover has become irrelevant Reich and others have contended therefore that traditional measurements of trade and payments balances have lost significance Reich has ar gued that even though the United States had a substantial trade and 24 Robert Reich The Work of Nations Preparing Ourselves for the 21st Century Capitalism New York Knopf 1991 296 T H E S T A T E A N D T H E M U L T I N A T I O N A L S payments deficit in the 1980s and 1990s this deficit was offset by a surplus in foreign production and sales by the subsidiaries of Ameri can multinational corporations The considerable increase in the internationalization of business in the 1990s gives support to those who argue that globalization has triumphed Onehalf or more of the products manufactured in the United States contain one or more components produced elsewhere and in some cases it is difficult to classify the nationality of the prod uct Are the Honda Accords many of which are made in the United States an American or a Japanese car Onehalf of all imports and exports in the world economy are estimated to be transactions be tween parent corporations and subsidiaries Although many more sta tistics and anecdotes could be cited to support the triumph of global ization I maintain that multinational transnational or if you prefer global firms are still national firms conducting international business MNCs and the NationState In an opposed view MNCs are considered products of their home economy Both industrial production and service industries are be lieved to be primarily nationbased 25 Although it is true that the total volume of goods produced overseas by American firms had increased significantly to around 20 percent of total production by the end of the century in the early twentyfirst century the remaining 80 percent of the American economy was still largely insulated from the world economy With few exceptions a firms primary market is still its home market and the policies of home governments weigh more heavily in the decisions of the firm than do those of host governments Moreover it is important to remember that foreign markets are also national markets and that corporate strategies must be geared to other national markets and to the policies of host governments 26 In addition internationalization of services and production are occur ring on a regional basis more frequently especially in Europe and North America And the policies and organizations of emerging re gional blocs tend to reflect the economic and political interests of their dominant member states 25 See Razeen Sally Multinational Enterprises Political Economy and Institutional Theory Domestic Embeddedness in the Context of Internationalization Review of International Political Economy 1 no 1 spring 1994 16192 26 Stephen Thomsen and Stephen Woolcock Direct Investment and European Inte gration Competition Among Firms and Nations London Royal Institute of Interna tional Affairs 1993 297 C H A P T E R E L E V E N An excellent exposition of the statecentric position can be found in Multinationals and the Myth of Globalization by Doremus et al mentioned earlier see footnote 16 This careful study which exam ines the behavior of American German and Japanese multinationals across a broad range of industrial sectors and activities successfully challenges the argument that technological economic and other transnational forces are leading to a convergence of state policies domestic economic structures and MNC behavior Instead the au thors find that the domestic structure and economic ideology of the home economy continue to affect powerfully the strategies and activi ties of MNCs They illustrate many significant differences among the firms of the three dominant economies and note that these differences can be explained by domestic factors such as the historical experience of the country differing economic ideologies the structure of the economy and the internal mechanisms of corporate governance Al though such firmspecific factors as the firms industrial sector and the characteristics of its products obviously affect the firms behavior the authors convincingly demonstrate that in the most fundamental areas of corporate strategy the domestic roots of firms usually remain decisive determinants of their behavior Many basic differences in corporate strategy and behavior reflect national institutional structures economic policies and social priori ties The United States has tended to take a laissezfaire attitude to ward business except when an especially strong case can be made for government intervention Germany on the other hand with its con cept of the social market and labormanagement partnership has traditionally placed a greater emphasis on the social or community responsibilities of the firm Japan has placed a high priority on main taining a strong indigenous industrial base and preserving core ele ments of the system of lifetime employment The resulting behavioral differences among American German and Japanese firms can be found in such core aspects of corporate behavior as patterns of strate gic investment intrafirm trade research and development corporate governance and longterm corporate financing American firms are more likely than German or Japanese firms to conduct basic R D in other countries they also are much more likely to invest abroad National differences are reflected too in the levels of intrafirm trade Whereas American firms are characterized by only a moderate level of intrafirm trade German firms have a higher level and Japanese firms have a very high level This brief list of national differences could be expanded considerably however there have been many 298 T H E S T A T E A N D T H E M U L T I N A T I O N A L S changes in national traditions and there is a modest trend toward convergence in corporate behavior and structure Arguing that the nationstate is still the principal actor in interna tional economic affairs proponents of the statecentric position assert that multinational corporations are simply national firms with foreign operations and that with few exceptions these firms remain deeply embedded in their national societies Their boards of directors and corporate management are composed predominantly of nationals and corporate leaders are responsible to stockholders or stakeholders who are also overwhelmingly nationals Even though this situation is changing relatively few firms have foreign nationals as corporate directors or members of top management Furthermore control over corporate finances is normally retained in the home country The key elements of research and development are also still retained in the home economy The strategy of the firm is influenced strongly by homecountry policies and other local considerations despite some common factors such as the importance of outsourcing to reduce costs corporate strategies are not converging toward a common pat tern And every government in one way or another promotes the in terests of its own national firms In short at the turn of the century there are no truly stateless global corporations and it will undoubt edly be decades before some do emerge if they do so at all There is no question that intercorporate alliances have gained great importance in the organization and functioning of international busi ness but the significance of this development can easily be and has been overstated Alliances among corporations of different nationali ties have created valuable crossnational or transnational ties yet in tercorporate alliances are notoriously unstable About 40 percent of these alliances last only about four years Their fragility or inherent weakness is because while corporate alliances may provide for coop eration in such specific areas as research on a particular technology or cooperation in a particular market the firms frequently continue to be fierce rivals outside the realm of the agreement Corporate alli ances are driven by a firms desire to increase its market share thus when situations change the interest of the corporation in the alliance may well change also Indeed corporate alliances far removed from commercialization are likely to fare better than other alliances All in all corporate alliances are matters of power and interest and are just as fragile as alliances among states In The Competitive Advantage of Nations Michael Porter demon strates that the national economy remains the predominant economic 299 C H A P T E R E L E V E N entity in the global economy In his analysis the home base of a mul tinational firm is the central determinant of the firms international competitiveness Multinational firms are and must continue to be na tional firms he argues because their competitive advantage is created in and must be maintained in their home economy Porter argues that the world economy is organized in clusters of industrial excellence that are nationbased The competitiveness of these national clusters such as the strength of Japanese firms in automotive products or of American firms in computers is determined by local factors and na tional policies National specialization strong national firms in par ticular industries and differentials in national wealth all indicate the continued importance of national economies Although American academics American corporate leaders and Japanese business consultants may propagandize the idea of the global corporation Japanese business and the Japanese government have definitely not accepted the idea that corporations have shed their nationality and become stateless The giant Japanese electronics con glomerate Matsushita is and always will be Japanese the task of the Japanese Ministry of International Trade and Industry MITI is and always will be to promote the interests of Matsushita and other Japa nese corporations Indeed the wellbeing of these corporations is con sidered identical to the wellbeing of Japanese society While Ameri cans may ridicule the remark of then Defense Secretary Engine Charlie Wilson that what is good for General Motors is good for the country the Japanese really do believe that what is good for Matsushita or Toyota is good for Japan Japanese society considers the overseas sales of Japanese products and the market share of Japa nese firms to be very important Nor are the concepts of the global corporation and the seamless world economy very appealing to those West Europeans who are attempting to create a unified European economy and strong European corporations that will compete effec tively against their American and Japanese rivals An International Regime for FDI and MNCs In light of the increased significance of the MNC in every facet of the global economy it is remarkable that there are no international rules to govern FDI not even any that are comparable to those affecting international trade and monetary affairs There are national bilateral regional and multinational agreements on MNCs and FDI but no overall comprehensive agreement Although the Uruguay Round moved toward establishment of such rules it fell far short of establish 300 T H E S T A T E A N D T H E M U L T I N A T I O N A L S ing a satisfactory regime to regulate FDI Many economists believe that an investment regime is unnecessary because markets will discipline errant states and firms Perhaps But this is asking too much of mar kets There is evidence to the contrary that an international agreement governing MNCs and FDI is desirable Such an agreement could lock in the trend toward liberalization of national policies affecting FDI eliminate distortions caused by governmental beggarthyneighbor policies and reduce conflicts among states and multinational firms Canadian trade negotiator Sylvia Ostry has suggested that a satis factory international investment regime would have to embody sev eral characteristics including the rights of establishment national treatment and nondiscrimination 27 The right of establishment means that firms of every nationality have the right to invest anywhere in the world The principle of national treatment requires that national governments must treat the subsidiaries of foreign firms as if they were their own In addition countries should not discriminate against the firms of particular countries this provision makes it necessary that national policies governing inwardFDI should be transparent An investment regime would also have to deal with the fact that every country restricts or limits investment in certain economic sectors such as finance culture and national security Another task would be to determine which types of national restrictions are legitimate and which should be prohibited Although these objectives are reasonable the political obstacles to incorporating them into an international in vestment regime are formidable Several important initiatives have been launched to govern MNCs and FDI but none have advanced very far by the beginning of the twentyfirst century FDI impinges directly on national economies and can infringe on national values and economic independence For this reason states especially less developed countries LDCs are reluc tant to surrender jurisdiction in these matters to an international body They fear domination by the huge corporations of the United States and other industrialized economies Moreover the very fact that MNCs operate across two or more national jurisdictions makes the task of framing an international regime extraordinarily difficult An investment regime would have to address such sensitive issues as taxation of foreign investment transfer pricing the prices charged by one subsidiary to another and governmental use of financial and other questionable inducements to attract foreign investment A par 27 Sylvia Ostry A New Regime for Foreign Direct Investment Washington DC Group of Thirty 1997 301 C H A P T E R E L E V E N ticularly vexing problem for Americas trading partners is the extra territorial application of American law not just to the foreign affiliates of American firms but also to those of foreign corporations For exam ple the HelmsBurton Act punishes foreign firms that deal with Cuba and is an especially infamous example of American efforts to impose its own laws and policies on other countries LDCs and other smaller states want protection against the concentration of power represented by the MNCs while corporations want guarantees against capricious actions by states there is understandable distrust on both sides Do Global Corporations Pose a Threat The large size of MNCs their market power and their pursuit of global strategies have raised fears in many groups and countries that they will become subjugated to and exploited by MNC globalization of production and services These concerns are not groundless as MNCs do represent huge concentrations of economic and frequently political power In the 1980s and 1990s a massive expansion of cor porate power took place in the United States Western Europe and elsewhere This merger wave was due to a number of factors the spectacular American stock market that has given some large firms the capital to take over others deregulation and the weakening of antitrust policy and new communications and other technologies that enable firms to oversee larger operations and enjoy greatly increased economies of scale Increasing concentration of power among media entertainment and telecommunications firms has been one of the most disturbing consequences of the merger movement and corporate aggrandize ment 28 Two prominent examples of such concentration are the merger of America Online Inc with Time Warner in January 2000 and Vodafone AirTouchs acquisition of Mannesmann AG The trend toward larger and larger firms in the media sector emerges from the logic of digital business itself Although competition is fierce and uncertainties are great in these sectors established firms enjoy econo mies of scale and find it easy to expand because the cost of replication of digits is relatively minuscule Thus once these firms whose exper tise and competitiveness lies in the manipulation of digits establish 28 Despite the antitrust action against Microsoft the Clinton Administration was very tolerant toward the rapid and extensive merger movement in the United States Secretary of the Treasury Summers and others argued that competition in the American economy is robust as globalization has more than offset the negative effects of mergers and reduced the pricing power of big firms In addition economies of scale and in creased efficiency achieved by mergers are believed to help consumers 302 T H E S T A T E A N D T H E M U L T I N A T I O N A L S themselves it is not costly to expand to incorporate other digital or wouldbe digital firms such as Time Warner In this way economies of scale in ecommerce appear to lead to massive scale in corporate structure Although the United States has been the forerunner of this development similar restructuring has begun in Western Europe Paradoxically corporate globalization is associated with both in creased scale and increased competition Although many fear in creased scale the benefits of increased competition are enormous whether or not they are appreciated Consider for example the bene fits to the American consumer and economy as a whole from Japanese exports and investments Japanese exports to the United States have meant that the American consumer has enjoyed a much wider range of goods of high quality and lower price The American economy as a whole has also benefited from Japanese FDI and introduction of such Japanese production techniques as lean production Would the American consumer and overall economy really have been better off if barriers to imports and investment had kept out Sony and Honda I doubt it very much Consumers and the overall economy in less developed countries also benefit from FDI and so do workers It is important to note that in general MNCs pay higher wages create more jobs than do domestic firms and have higher labor standards and the economy gains capital and technology from the MNCs This means that MNCs can be particularly important to LDCs especially to those where agriculture is predominant MNCs in Turkey for ex ample pay 124 percent of average Turkish wages 29 Maintenance of a strong regulatory system and encouragement of firms of many nationalities to invest and compete in the local market can provide an effective response to the dangers of corporate power Despite these and other safeguards a global economy populated by powerful multinational firms is a daunting prospect especially for the firms and governments of small poor countries There is a great temptation to close national borders to imports and to foreign direct investment However such a response to the increasingly integrated global economy could be extremely costly Without access to foreign capital and technology economic development would be very diffi cult or even impossible as Nobel Laureate Arthur Lewis from the Third World himself Barbados has pointed out developing coun tries must have large infusions of outside capital to build the costly physical infrastructure required for their economic development 30 Debt forgiveness foreign aid and technical assistance could help 29 The Economist 29 January 2000 21 30 W Arthur Lewis The Evolution of the International Economic Order Princeton Princeton University Press 1978 303 C H A P T E R E L E V E N close the richpoor gap but these measures are hardly enough Al though for many globalization is a threat it is also part of the solu tion to underdevelopment the industrial success of the emerging markets of East Asia exemplify the importance of trade foreign in vestment and technology imports The argument that small countries cannot compete in the world of the strong is nonsense and is contradicted by experience Tiny Finland has established itself as a leader in wireless telephony Nokia and other hightech industries Israel is a world leader in many technologi cal developments Ireland has reversed a century and a half of eco nomic stagnation by making itself an attractive site for investment by hightech firms Among industrializing and less developed countries India has become a major international player in computer software Taiwan has a flourishing semiconductor and computer industry and Singapore and Hong Kong have outstanding records of economic suc cess However if an LDC is to join this league of small but very successful countries it must have an honest and competent govern ment invest heavily in education at all levels respect international property rights encourage entrepreneurship support a diversified and excellent national program of R D and pursue sound macroeco nomic policies A nation that is unwilling to assume these crucial re sponsibilities is quite unlikely to succeed in the global economy and risks domination by foreign firms Unfortunately too many less de veloped and postcommunist economies are at serious risk Conclusion The role of the MNC has grown increasingly important in the inte gration and organization of the global economy Yet it is important to appreciate that most economic activities are still overwhelmingly nationally based Moreover the prevailing idea that MNCs are des tined to rule the global economy may turn out to be quite misleading The global economy rests and must continue to rest on a secure social and political foundation and there is no guarantee that this founda tion will survive in the decades ahead As the economic historian Wil liam Parker reminds us in the late nineteenth century the interna tional capitalist system began to break down because of a mismatch between new largescale capitalist firms and the interests of many Eu ropeans 31 Today this sober analysis would have to be expanded to include a global economy composed of diverse cultures and interests 31 William N Parker Capitalistic Organization and National Response Social Dy namics in the Age of Schumpeter in Richard H Day and Gunnar Eliasson eds The Dynamics of Market Economies Amsterdam NorthHolland 1986 351 304 CHAPTER TWELVE The State and Economic Development T HE HERCULEAN task of raising the great mass of humanity from poverty to acceptable levels of economic welfare is one of the most difficult tasks facing the world economy 1 There is intense dis agreement among economists public officials and other experts over the best ways to achieve this goal Indeed there is not even a generally accepted commitment to accord priority to economic development Early attempts by India and other less developed countries LDCs to make economic development an explicit objective of the postwar world economy at the 1944 Bretton Woods Conference were rejected by the United States and other industrialized countries 2 The World Bank the International Monetary Fund and regimes governing the world economy were established primarily to serve the interests of the dominant powers Although industrialized countries have subse quently provided technical and financial assistance and given trade preferences they have continued to resist LDC demands for a devel opment regime Among both scholars and public officials there are strong disagree ments regarding the relative importance of the state and the market in economic development these disagreements have been central to the conflict between the developed and the less developed countries 3 Throughout much of the postwar era a debate has raged between the neoclassical proponents of reliance on the market and the proponents of state intervention In the early postwar period 19451970 devel opment economics which emphasized the role of the state was pre eminent Development economists argued that developing countries required an activist government moreover they believed that the in 1 A sweeping study of why some nations have become rich and most others have remained poor is David S Landes The Wealth and Poverty of Nations Why Some Are So Poor and Some So Rich New York W W Norton 1989 2 This discussion is based on Harold Jamess magisterial history of the IMF Interna tional Monetary Cooperation Since Bretton Woods Washington DC International Monetary Fund New York Oxford University Press 1996 3 A very useful history of the debate over the best route to development is John Rapley Understanding Development Theory and Practice in the Third World Boul der CO Lynne Rienner 1996 305 C H A P T E R T W E L V E ternational community should play a central role in LDC develop ment Then during the 1970s and 1980s the neoclassical belief in the free market triumphed both in academia and in international in stitutions and the ideology of neoliberalism and the doctrine of structural adjustment became dominant in the International Mone tary Fund and the World Bank 4 In the late 1980s and early 1990s the theory of the developmental state arose to challenge neoliberalism Differing with the policy pre scriptions of neoliberalism but consistent with development econom ics the theory of the developmental state emphasized that the state should play the central role in economic development The contro versy between proponents of the developmental state and of neo liberalism has focused on differing interpretations of the rapid and extraordinary economic success of the Newly Industrializing Coun tries NIEs of East and Southeast Asia Neoliberalism argues that the success of these economies has been due to their reliance on the mar ket and the minimal role of the state in the economy The theory of the developmental state on the other hand credits the central role of the state for the rapid industrialization of the East Asian economies This position gained many adherents among noneconomist scholars of economic development Then in 1997 the East Asian financial crisis shifted the weight of the argument to the neoliberal emphasis on the importance of the market and the dangers of state intervention in the economy Proponents of the developmental state strongly dis puted this assessment and argued that the crisis was caused by inter national economic and political pressures And so the debate contin ues To a significant degree the fate of the great mass of mankind located in LDCs will be affected by whether the statecentric or mar ketcentric approach to economic development is ultimately domi nant To understand the nature of this crucial debate about the best path to economic development one must begin at its origins in the early postWorld War II era The Rise and Demise of Development Economics Development economics was the first systematic effort to deal with the problems of the less developed countries 5 Flourishing in the 4 Neoliberalism refers to the application of the principles of neoclassical economics to economic development and other aspects of economic affairs Neoliberalism and structural adjustment will be discussed in more detail below 5 A useful overview of theories and writings on economic development is James M Cypher and James L Dietz The Process of Economic Development London Routledge 1997 306 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T 1940s and 1950s this theory became the predominant theoretical po sition in the United States and elsewhere to explain why some nations remained impoverished and what should be done to overcome the problems of the LDCs In a strict sense of course the term develop ment theory was a misnomer Actually a number of specific devel opment theories competed with one another these theories differed in their analysis of the precise causes of economic underdevelopment and appropriate solutions to economic problems Moreover develop ment theory as a whole was a collection of general ideas rather than a single coherent theory Among the more prominent members of the development school were Albert Hirschman Arthur Lewis Gunnar Myrdal Raul Prebisch Paul RosensteinRodan and Max Singer These economists attempted to provide an overall explanation of eco nomic underdevelopment and a strategy to lift the less developed na tions out of poverty Development theory assumed that the less developed countries were fundamentally different in kind from the more advanced indus trialized countries and functioned according to different economic principles Development theorists believed that although the precepts of neoclassical economics were applicable to the advanced industrial ized economies these theories were inapplicable to the LDCs because of their special conditions For example as Arthur Lewis argued less developed economies were burdened by excess labor and low produc tivity in the agricultural sector surplus workers were paid subsistence wages and constituted an immense reservoir that could be tapped to accelerate economic development 6 These theorists also noted that the LDCs which were mainly exporters of commodities and tropical products suffered from unfavorable terms of trade Trade pessi mism led these economists to believe that trade could not serve as an engine of growth as it had for developing countries in the north during the nineteenth century Furthermore a number of market fail ures including inflexible economic structures very low savings rates and poor educational systems were believed to have locked the less developed economies into a vicious circle from which they could not escape without a strong interventionist state and significant interna tional assistance Development theorists also believed the less developed countries were victims of latelate development These economists argued that in the nineteenth century the thendeveloping countries such as 6 W Arthur Lewis Economic Development with Unlimited Supplies of Labour Manchester School 22 May 1954 307 C H A P T E R T W E L V E Japan and Germany enjoyed what Alexander Gerschenkron called the advantages of backwardness when they were able to draw upon the capital technology and experience of the early developers 7 The late late developing countries of the second half of the twentieth century on the other hand were considered to be so extremely far behind that they would face overwhelming problems competing with more developed economies and would be unable to catch up with the more advanced economies unless extraordinary measures were taken Development theorists therefore believed that the state and the international community had to play major roles The industrialized economies were judged so strong that LDC firms could not possibly compete against them and acquire market shares in the international economy This view discouraged private entrepre neurship and undermined the belief in free trade and open markets Some proponents of development theory thus believed that the path to economic development was trade protectionism and the strategy of import substitution and that every LDC should build an industrial structure behind high tariff walls These ideas were set forth by Raul Prebisch the Economic Commission for Latin America ECLA and the United Nations Commission for Trade and Development UNC TAD and became important in the importsubstitution strategies of Latin America For Swedish economist Gunnar Myrdal the essence of the underde velopment problem was that the less developed economies were caught in a vicious circle of poverty or according to his formulation were locked into a process of circular and cumulative causation from which they could not escape without a massive stateled effort and generous international assistance 8 Myrdals argument proceeded like this The less developed countries by definition were impover ished As these countries were poor they had very low rates of na tional savings Because they had low savings rates they also had low investment rates Because they had low investment rates their indus tries were inefficient and uncompetitive in world markets Because their industries had low rates of productivity growth and were un competitive these countries continued to be impoverished And be cause they were poor and so on The task of economic develop ment therefore was to break this vicious circle of poverty in which the less developed countries were trapped 7 Alexander Gerschenkron Economic Backwardness in Historical Perspective Cam bridge Harvard University Press 1962 8 Gunnar Myrdal Economic Theory and Underdeveloped Regions New York Harper Torchbooks 1957 308 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T Following the implications of such ideas development economists formulated the strategy of the Big Push which would enable LDCs to break through both domestic and international barriers to success ful economic development Set forth originally in an influential 1943 article by development economist Paul RosensteinRodan the idea of the Big Push may be said to have launched the field of development economics 9 He argued that the state had to play a much more activist interventionist role in the economy than was needed in more ad vanced economies In LDCs it had to overcome such market failures as the lack of entrepreneurship low national savings and various economic uncertainties that weighed down these backward econo mies In addition due to low national savings rates and the absence of a strongly entrepreneurial private sector the state itself had to be come an entrepreneur and promote public investment Development economists however differed among themselves about a number of issues such as the importance of balanced growth strategies In addition development economists prescribed that industrialized nations should provide massive foreign aid and other forms of finan cial and technical assistance Moreover they argued that the devel oped countries ought to extend trade preferences to the less developed countries and should not require the latter to reciprocate by opening their less competitive economies If such policies were followed and a development regime were established development economists be lieved that both the more developed and the less developed economies would benefit Their optimistic belief that every economy had an in terest in the development of all set development economists apart from dependency theorists economic nationalists and Marxists all of whom regarded the interests of undeveloped and those of devel oped economies as antithetical Triumph of Neoliberalism The late 1970s and early 1980s witnessed the defeat of both develop ment economics and the LDC strategy of importsubstitution that had been intellectually supported by development theory The founda tions for the overthrow of development economics within the eco nomics fraternity were laid in the 1960s with a profound change in the character of economic thought and methodology The writings of 9 Paul N RosensteinRodan Problems of Industrialisation of Eastern and South Eastern Europe Economic Journal Quarterly Journal of the Royal Economic Society 53 nos 210211 JuneSeptember 1943 202211 309 C H A P T E R T W E L V E development economists had been mainly literary and descriptive one can read Arthur Lewis and Albert Hirschman for example and only rarely encounter a graph or an equation Then in the 1960s influ enced by Paul Samuelsons Foundations of Economic Analysis 1949 and the methodological writings of other neoclassical economists for malization and abstract modeling began to displace the more literary style of most economists 10 This shift meant that if an idea however intellectually interesting it might be could not be expressed in an abstract model it was of little or no interest to the rising generation of mathematically inclined and modeloriented economists coming out of the Massachusetts Institute of Technology and elsewhere One unfortunate consequence of this development was that problems of economic development suffered neglect because they were impossible to model 11 In addition to this methodological shift from literary to formal analysis there was an intellectual revolution against development economics in the 1970s As Hirschman pointed out in an intriguing essay entitled The Rise and Fall of Development Economics the emergence of development economics had been facilitated by the Keynesian revolution that posited two different types of economics and therefore also posited differing policy prescriptions 12 On the one hand was what Keynes called classical economics with its em phasis on a fullemployment equilibrium this classical economic uni verse was composed of flexible prices and wages that could easily adjust to changes in demand and thereby restore a fullemployment equilibrium In this economic universe the market did all the work and there was little that the state could or should do On the other hand Keynes pointed out that there were situations characterized by market failure as in the Great Depression where equilibrium could not be restored by the free play of market forces and the government therefore had to intervene with demand manage ment policies macroeconomic policies that would reestablish a full employment equilibrium Such departures from fullemployment 10 Paul A Samuelson Foundations of Economic Analysis Cambridge Harvard Uni versity Press 1983 11 The interesting story of this methodological shift has been told by Paul R Krug man in his Development Geography and Economic Theory Cambridge MIT Press 1995 12 Discussed in Albert O Hirschman The Rise and Fall of Development Econo mies in Hirschman Essays in Trespassing Economics to Politics and Beyond New York Cambridge University Press 1981 Chapter 1 See also Lloyd G Reynolds The Three Worlds of Economics New Haven Yale University Press 1971 310 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T equilibrium were produced by economic behavior fundamentally dif ferent from that predicted by classical economics and that thus neces sitated state intervention in the economy in order to overcome market failures In effect Keynesianism not only created a rationale for gov ernment intervention but implied that classical economics was not a unified universal science applicable to every economy and economic situation In this way Keynesianism supported the fundamental as sumption of development economics that less developed economies were different from developed economies and therefore the state should play a central role The attack on Keynesian economics in the 1960s and 1970s by monetarists and by the theory of rational expectations undermined the intellectual foundations of development economics The essence of this criticism was that there is only one economics and that eco nomics is a universal science equally applicable to all societies These arguments challenged the basic idea of development economics that the LDCs were fundamentally different from developed economies and functioned according to a different economic logic The critics of development economics argued that such behavioral assumptions of neoclassical economics as individual rationality the principle of mar ginal utility and the importance of relative prices were as applicable to less developed as they were to developed countries For example in an important study for which he received the Nobel Prize Theo dore Schultz demonstrated that LDC farmers were rational maxi mizers who responded to market incentives and were not the hapless people depicted by development economists 13 Neoclassical economists argued that the principal source of under development is government policies that distort economic incentives inhibit market forces and actually work against economic develop ment 14 Neoclassical economists argued that the LDCs problems were due to government failures rather than as development economists contended to market failures requiring government intervention The 13 Theodore W Schultz Transforming Traditional Agriculture New Haven Yale University Press 1964 Schultzs research showed that peasants were rational and re sponded to price incentives In one of the more bizarre episodes in the history of the Nobel Prize for economics the award was made jointly to Arthur Lewis and Theodore Schultz for contributions to economics that contradicted one another It is hardly con ceivable that two physicists would get the physics prize for research that came to op posed conclusions about the nature of the universe This curious episode is discussed by Hirschman Essays in Trespassing Economics to Politics and Beyond Chapter 1 14 An important critique of development economics and statement of the neoclassical position is Ian M D Little Economic Development Theory Policy and International Relations New York Basic Books 1982 311 C H A P T E R T W E L V E LDC state neoclassical economists concluded was the problem and not the solution in the failure of these economies to develop They pointed out that for example reckless government policies were re sponsible for the excessively high rates of inflation and the huge gov ernment debts that distorted economic incentives and discouraged en trepreneurship Their message to LDC governments was to get the prices right rely on the fundamentals of the market and get their hands off the economy If these simple neoclassical policy prescrip tions were pursued they contended the less developed economies would permit a proper environment to emerge in which private initia tives would lead to economic development This neoclassical attack on development economics considered the world of economics to be unitary and the theories and principles of neoclassical economics to be just as applicable to the less developed countries as they were to the developed countries State intervention however had distorted these economies and bore primary responsi bility for their failure to develop Fiscal irresponsibility hyperinfla tion and markets closed to international competition were among the major problems afflicting them Neoclassical economists totally rejected the argument that the less developed economies were caught in a vicious circle of poverty and cumulative causation that could be broken only by state intervention and massive international assis tance Instead they argued that if the governments of less developed countries stepped aside pursued sound or marketconforming eco nomic policies and opened their markets to the world their growth rates and national wealth would eventually converge with those of the more developed countries That is market openness fiscal disci pline and noninterventionism constituted the route to economic de velopment By the late 1970s neoclassical orthodoxy had triumphed in the economics profession Development economics literally disappeared and development economists despaired and took up other intellectual interests Albert Hirschman for example began to write about social theory and the writings of the pioneers of development economics rarely appeared on the syllabi of American departments of economics The ideas and policy proposals of development economics survived only in those less developed countries that continued to pursue im portsubstitution strategies and in certain specialized agencies of the United Nations that advocated the strategy of importsubstitution However even in these remaining outposts development economics and the policies it advocated suffered a severe defeat in the 1980s 312 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T The Debt Crisis and Structural Adjustment The international debt problem that surfaced in the Mexican financial crisis of 1982 spread rapidly throughout the developing world espe cially in Latin America and a number of African and East European countries When Arab oilproducing countries had suddenly and sharply raised oil prices in 1973 severe balance of payments deficits were incurred by LDCs Recycling of the resultant OPEC surplus to deficit LDCs through loans by large international banks increased the likelihood of an eventual crisis The decision of the Federal Reserve in the fall of 1979 did precipitate a crisis when it shifted from a loose to a tight monetary policy in order to defeat hyperinflation LDC debtors then suddenly found themselves saddled with huge interest payments on their debt and were unable to service their debt because of the global recession and loss of income from their exports The consequent LDC debt crisis during the 1980s had a devastating impact on a large number of developing countries and subsequently also had profound consequences for the economic policies of the LDCs the role of the International Monetary Fund in economic de velopment and the relations between industrial and developing econ omies In effect the debt crisis signaled the failure of the development strategy based on importsubstitution and of the idea that the state should play a substantial role in the less developed economy Throughout the 1970s LDCs had financed their economic develop ment through sovereign borrowing that is government borrowing in Western capital markets a strategy that permitted escape from de pendence on both northern MNCs and the conditionality policies of the IMF and the World Bank 15 By the mid1980s reliance on bank loans had become impossible Later in the decade the collapse of the Soviet Union and the failure of its command economy further strengthened belief in the superiority of the market system However it was the LDC debt crisis more than any other development that led to the triumph of the doctrine of neoliberalism and the policy of structural adjustment When Mexico informed the United States in 1982 that it could no longer service its huge debt the Federal Reserve launched a concerted effort to contain the crisis so as to prevent damage to the American banking system and extension of the crisis to other debtor countries in Latin America While the Fed arranged for shortterm loans to 15 Conditionality refers to the imposition by the IMF of certain requirements that must be met before assistance is forthcoming 313 C H A P T E R T W E L V E prevent a Mexican default the IMF assumed responsibility for work ing out a longterm solution The arrangement for dealing with the Mexican debt crisis became the model followed with other LDC debt ors Although the debtors attempted to present a united front against imposition of the strict terms dictated by the lender countries the latter were in firm control However it soon became apparent that the initial assessment of the debt crisis had been deeply flawed The debt problem in many countries was really one of insolvencythey could not service their debts without major economic and structural reformsrather than a liquidity problem that could be solved by shortterm lending and policy adjustments Many debtors could not possibly repay or even service pay the interest on their debts under the best of circumstances It became obvious that a longterm more fundamental solution to the debt problem was required In 1985 responding to this reassessment of the nature of the debt crisis US Secretary of the Treasury James Baker initiated the policy of structural adjustment 16 This doctrine resulting from the neoortho doxy of the 1970s assumed that the debtor countries persistent trade and fiscal imbalances had deep structural causes Therefore along with changed macroeconomic policies such structural reforms as a shift toward exportled growth reductions of the role of the state in the economy and public sector reforms were required This approach was also based on the lessons drawn from the East Asian successes in the 1960s and 1970s This new conventional wisdom coincided with rising opposition to big government in the United States the United Kingdom and elsewhere The doctrine of structural adjustment meant that a debtor country applying for financial assistance from the IMF andor World Bank had to commit itself to a number of stringent economic and structural reforms Over the short term these reforms were intended to achieve balance of payments adjustment over the long term restructuring of these economies would be necessary if they were to return to success ful economic development Underlying this significant policy reorien tation of lender governments and the IMF was the realization that only more rapid rates of economic growth would enable the debtors to overcome the problem of national insolvency The doctrine of structural adjustment was based on what John Wil liamson called the Washington Consensus 17 This term refers to 16 Joan M Nelson ed Economic Crisis and Policy Choice The Politics of Adjust ment in the Third World Princeton Princeton University Press 1990 17 John Williamson Democracy and the Washington Consensus World Devel opment 21 no 8 1993 132936 314 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T Williamsons perception of broad agreement among public officials in both the industrial economies and international institutions on the importance of the neoliberal program for economic development and its emphasis on free markets trade liberalization and a greatly re duced role for the state in the economy Although some LDCs charged that the demand for structural adjustment was a new form of capitalist imperialism the LDCs had little choice other than com pliance if they wanted financial assistance While later developments complemented or supplemented the policy of structural adjustment this basic approach soon defined the position of the industrial coun tries and the IMF toward the LDCs and economic development Belief that the role of the state in the economy should be drastically reduced and the economy should be opened to the outside world was a vital component of this neoliberal consensus governments should deregulate and privatize the economy as well as shift from an import substitution to an exportled growth strategy Another component of structural adjustment was that governments should pursue prudent fiscal and monetary policies and should definitely maintain balanced budgets in order to eliminate runaway inflation It was particularly important that the economy should get prices right and not permit government policies to distort them After such reforms it was ar gued private initiatives and desirable social outcomes would be likely to emerge Nations were encouraged to recognize that economic de velopment requires an effective state meaning a government run by incorruptible economic technocrats Although a number of impor tant disagreements primarily of a political nature persisted within this broad neoliberal agenda the Washington Consensus became the principal approach of the developed countries to the less developed countries 18 The debt crisis transformed the international role of the IMF and the World Bank The IMF had originally been established as a mone tary institution to manage the Bretton Woods system of fixed ex change rates for example it provided shortterm loans to deal with balanceofpayments problems To receive such a loan the recipient country had to fulfill certain macroeconomic policy conditions con ditionality These conditions were imposed to force the country to bring its international payments back into equilibrium In response to the debt crisis the role of the IMF changed dramatically as it began 18 These political disagreements have been over such matters as economic priorities the speed and sequencing of economic liberalization and how to reform the civil ser vice These highly controversial issues are at the core of the political problems that must be resolved if economic development is to succeed 315 C H A P T E R T W E L V E to make mediumterm loans In addition implementation of the doc trine of structural adjustment meant that conditionality was ex panded from requirements of changes in macroeconomic policy to fundamental changes in microeconomic policies and in the overall economy This made the IMF become an economic development agency with considerable influence over the economic affairs of less developed countries With its response to the debt crisis the Fund joined the World Bank to play a major role in the affairs of both developing economies and the transitional economies in Eastern Europe and the former So viet Union Warranted or not the Fund became known as the bad guy and was subjected to severe criticism by many economists less developed countries and politicians on both the political left and right The Left turned against the IMF because of its inflexible de mands that governments seeking assistance had to carry out major reforms and austerity programs whose impact proved heaviest on the poor The Right believed that IMF policies had actually harmed less developed countries and thus preferred a market solution to the fi nancial troubles of developing and transitional economies Opposi tion to the Fund reached its zenith during the 1997 East Asian finan cial crisis and led to proposals for fundamental reforms Theory of the Developmental State In the late 1980s and early 1990s the theory of the developmental state arose to challenge neoliberal orthodoxy explaining the rapid and successful industrialization of the Newly Industrializing Economies NIEs in East Asia According to this position the outstanding eco nomic success of Japan and other East Asian countries was due to their adoption of the developmental state model in which the state had to play the central role in guiding economic development and had to lead rather than follow the market The acrimonious debate between proponents of the developmental state and proponents of the neoliberal marketcentered approach has become central to deter mination of the best route to successful economic development 19 19 Two useful analyses of this debate are Stephan Haggard Pathways from the Pe riphery The Politics of Growth in the Newly Industrializing Countries Ithaca Cornell University Press 1990 and Richard F Doner and Gary Hawes The Political Econ omy of Growth in Southeast and Northeast Asia in Manochehr Dorraj ed The Changing Political Economy of the Third World Boulder Colo Lynne Rienner 1995 Chapter 6 316 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T The neoliberal interpretation of the extraordinary economic success of the NIEs South Korea Taiwan Hong Kong and Singapore was that these economies had pursued market conforming economic development strategies markets rather than government policies had determined the path of development The extraordinary performance of these miracle economies neoliberal thinkers believed provided strong support for the Washington Consensus the doctrine of struc tural adjustment and neoclassical reliance on the market According to this interpretation East Asian governments had followed neolib eral policy prescriptions they had opened their economies to the world reduced the role of the state in the economy to permit markets to function properly and pursued exportled growth strategies This interpretation of Japanese and East Asian economic success however was challenged by theorists of the developmental state who argued that success was due to the crucial role played by the state and its industrial policies in the process of economic development The theory of the developmental state is really a collection of sev eral theories sharing important ideas These several theories assert that East Asian governments have played a central role in the devel opment of their economies Two outstanding interpretations of East Asian economies as developmental states are found in Alice Amsdens Asias Next Giant 1989 which analyzes the industrialization of South Korea and Robert Wades Governing the Market 1990 which deals with the industrialization of Taiwan 20 Although Ams dens and Wades ideas differ on a number of issues I shall emphasize those points on which they and most other proponents of the devel opmental state are in agreement Theories of the developmental state argue that the governments of Taiwan South Korea and the other NIEs devised an array of incen tives that encouraged private investment in strategic industries Also through a variety of techniques these governments played a key role in creating an entrepreneurial class identified critical economic areas for development and exposed priority sectors to international compe tition that forced them to become efficient These state policies en couraged development of an industrial and economic structure that would not have arisen merely in response to market signals Accord ing to the theory of the developmental state the policies of these governments deliberately got prices wrong in order to change the 20 Alice H Amsden Asias Next Giant South Korea and Late Industrialization New York Oxford University Press 1989 and Robert Wade Governing the Market Eco nomic Theory and the Role of Government in East Asian Industrialization Princeton Princeton University Press 1990 317 C H A P T E R T W E L V E behavior of firms they also used nonprice means to alter firm behav ior Scholars argue that this stateled industrialization strategy worked by using the price mechanism to encourage private entrepre neurs to take actions that the government considered to be in the interest of rapid industrialization The industrial protectionist and other policies employed by the developmental state were based on the assumption which had been shared by members of the first generation of development theorists that these economies suffered from the consequences of late late industrialization Market failure was assumed to be prevalent among these less developed economies and market failure necessi tated an active role for the state Governing elites believed that their societies faced collective action problems that is they had to find a way to motivate members of their societies to work together State policies were needed to bring private returns in line with public re turns States had to create an incentive structure to ensure that private entrepreneurs invested in those economic activities that would be the most socially beneficial In addition to trade protection and govern ment subsidies their industrial policies included such financial re pression policies as selective credit allocation and deliberate distor tion of interest rates in order to channel cheap credit to favored economic sectors Elites also believed that government policies should anticipate the future comparative advantage of the economy and that industrial policy should lead rather than follow the market 21 Although proponents of the developmental state agree with neo classical economists that the strategy of exportled growth was a key factor in the economic success of the East Asian economies they ar gue that neoclassical analysis is not sufficiently comprehensive For example they ask why business firms selected particular products for export 22 As Amsden points out in her study of South Korean industri alization that government used a number of mechanisms to promote particular industrial sectors and encourage export drives including export contests to promote rapid industrialization of those sectors considered of strategic importance to the overall economy Those in dustries that performed best in export markets were especially favored by government industrial policies and programs of financial assistance 21 Richard Auty makes the interesting point that industrial policy was a consequence of the uncertain political situation after the defeat of the United States in Vietnam Richard M Auty Economic Development and Industrial Policy Mexico Indonesia and China New York Mansell 1994 22 Another area of disagreement has been the relationship of exports and growth Did exports cause growth as neoclassical economists assume or did growth cause exports as proponents of the development state believe 318 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T Proponents of the developmental state maintained that the theory of the governed market to use Wades appropriately descriptive term rather than the neoclassical theory of the free market accounted for the outstanding economic success of the East Asian NIEs The theory of the developmental state maintains that the East Asian state was able to play a guiding role in economic development be cause of a number of unique domestic and international factors In all these societies the state has been relatively autonomous and there fore able to pursue policies free from public pressure Yet this state autonomy was deeply embedded in a society where the state worked very closely with business interests to promote rapid industrializa tion 23 Some observers believe that such Asian social values as hierar chical deference a tradition of hard work and subordination of the individual to the community played a crucial role celebration of Asian values also provided ideological support to the authoritarian regimes of the region The national political economy was based on trust and subordination rather than Westernstyle compliance and ac countability Although these states were authoritarian they also car ried out important reforms and implemented policies favorable to economic growth and social harmony for example they promoted land reform education and income equality At the core of the developmental state and the reason for its out standing success were close ties among government local banks and industry These intimate relationships which Wade calls alliance capi talism facilitated channeling bank capital into promising industries and thus promoted rapid industrialization At the same time domestic governments frequently restricted both foreign direct and portfolio in vestments by international firms and thus insulated their economies from disruptive external influences Although this system produced lia bilities disproportionate to their assets in the larger enterprises such as the South Korean chaebol the system worked very effectively and was stable as long as local governments controlled domestic financial mar kets and the capital account a situation that changed dramatically in the 1990s and was a significant factor in the post1997 East Asian financial crisis Development of these economies was also supported by a number of sociological and political factors such as a hardwork ing labor force and only moderate levels of inequality In addition to these domestic features a number of international factors were of benefit to the Newly Industrializing Economies NIEs As Cold War allies of the United States they received special 23 Peter Evans Embedded Autonomy States and Industrial Transformation Princeton Princeton University Press 1995 319 C H A P T E R T W E L V E treatment in American economic and other policies National security concerns motivated Taiwan and South Korea in particular to place a high priority on rapid economic development Moreover as some writers have pointed out Japanese imperialism had left a legacy of physical infrastructure an educated population and effective institu tions that favored economic development Another very important factor was that these economies were able to pursue an exportled growth strategy because of the global freetrade environment Despite the importance of East Asias unique domestic and interna tional circumstances governments in other parts of the world have looked to this Asian experience for guidance and have sought to in corporate key components of that developmental model into their own strategies Although many developing economies have been strongly influenced by the neoliberal agenda of exportled growth and struc tural reforms and have made important marketconforming reforms many also have tended to be very pragmatic and have not been pre pared to adopt completely the neoliberal emphasis on open markets and noninterference in the economy by the state Also they continue to be wary of what Stephan Haggard calls deep integration in the global economy 24 As a consequence industrializing economies and even most developed countries tend to pursue strategies of selective opening to the world economy in which the state mediates between domestic and international markets and thereby attempts to guide the economy so as to promote the nations economic and political inter ests For example although Brazil has given up its futile effort to create its own computer industry it has continued to use protectionist devices to promote the development of a Brazilian automobile industry For Latin America and other industrializing countries the ultimate attractiveness of the theory of the developmental state is that it ap pears to be the appropriate means for combining economic develop ment with political independence 25 Economic development and in dustrialization have never been considered ends in themselves The ultimate goal of developing economies has always been to achieve economic autonomy and political independence In a world of highly concentrated market power states desire to control their national economies as much as possible and do not want their position in the 24 Stephan Haggard Developing Nations and the Politics of Global Integration Washington DC Brookings Institution 1995 25 I am indebted to Peter Kingstone of the University of Vermont for his assistance in my understanding of these matters A relevant interpretation is Luiz Carlos Bresser Pereira Economic Crisis and State Reform in Brazil Toward a New Interpretation of Latin America Boulder Colo Lynne Rienner 1996 320 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T international division of labor to be determined solely by the free play of market forces Despite the strong support in many LDCs for the theory of the developmental state most neoclassical economists reject it Paul Krugman writing in the Foreign Affairs journal 1994 attacked the idea that East Asian governments had succeeded because government policies had substantially raised the productivity levels of their econo mies 26 Krugman argued that these societies were successful primarily because of their rapid accumulation of capital and labor the basic factors of production He further argued that the development experi ence of these countries supported the neoclassical growth model there was no miracle While there had been a onetime leap for ward future growth would require increased emphasis on innovation and productivity growth except in China Whether or not Krugmans critique is correct these societies should at least be credited for effec tive mobilization of their human and material resources The East Asian Miracle Project The developmental state interpretation of East Asias economic suc cess could have remained an academic dissent from the Washington Consensus however the Japanese governments agreement with the theorys basic assumption about the important role of the state in economic development gave prominence to the theory 27 In the 1980s 26 Paul R Krugman The Myth of Asias Miracle Foreign Affairs 73 no 6 No vemberDecember 1994 6278 The emphasis on factor accumulation rather than technological progress was first set forth by Alwyn Young in the 1992 NBER Macro economic Annual Krugman drawing upon Youngs finding downplayed the East Asian miracle The success of East Asia he argued was attributable mainly to capi tal investment and high population growth rather than to technological innovation and productivity growth This argument is extended in Alwyn Young The Tyranny of Numbers Confronting the Statistical Realities of the East Asian Growth Experience Quarterly Journal of Economics 110 August 1995 64180 Other economists have given support to the important role of technological progress in the miracle This work is discussed in Robert J Barro The East Asian Tigers Have Plenty to Roar About Business Week 27 April 1998 24 A report by the Parisbased Organization for Economic Development supports the KrugmanYoung position that these econo mies suffered from serious weaknesses in technological development skilled workers and other technologyrelated matters Organization for Economic Development Asia and the Global Crisis The Industrial Dimension Paris Organization for Economic Development 1999 And thus the argument continues 27 The Japanese criticism of the Washington Consensus is set forth in The Overseas Economic Cooperation Fund Issues Related to the World Banks Approach to Struc tural Adjustment Proposal from a Major Partner October 1991 OECF Occasional Paper No 1 unpublished 321 C H A P T E R T W E L V E the World Bank WB having subscribed to the Washington Consen sus rejected what the Japanese believed to be their own superior model of economic development based on the central role of the state in the economy The Japanese had been especially irked by the WBs World Development Report 1991 which praised the neoliberal posi tion and had little good to say about the Japanese model 28 As John Page a high World Bank official had told a Princeton University audience the Japanese continued to sign the checks but they felt that the World Bank did not appreciate the reasons for Japans own out standing economic success Japan wanted the bank to pay greater attention to the distinctive features of the East Asian economies It also wanted greater emphasis in World Bank policy on the important and necessary role of the state in economic development rather than a nearly exclusive emphasis on macroeconomic issues and structural adjustment Therefore the Japanese insisted that the World Bank carry out an empirical study to determine the specific reasons for the economic success of the East Asian economies before deciding on pol icy advice for other developing countries This Japanese demand gen erated what became known as the East Asian Miracle Project The East Asian Miracle Project was intended not only to meet Japa nese concerns but also to review the World Banks policies toward less developed countries and to evaluate alternative approaches to economic development John Page director of the Project labeled one possible approach fundamentalism that is the Solow or neoclassi cal theory of economic growth which attributes economic growth primarily to getting the prices right and to accumulation of the basic factors of production 29 The alternative approach pejoratively labeled mystical by Page was based on the theory of endogenous growth set forth by Paul Romer and other economists This new growth theory implied that state interventionism could accelerate the process of economic growth and that through industrial and other policies the state could expedite technological innovation and productivity growth The Project was intended to determine once and for all whether economic growth is better explained by factor accu mulation and thus accords with neoclassical theory and World Bank orthodoxy or by technological advance and productivity growth which would be in accord with endogenous growth theory and the idea of the developmental state 28 World Bank The Challenge of Development World Development Report 1991 Washington DC World Bank 1991 29 As the reader will recall according to this theory technological change and produc tivity growth are exogenous and the role of the state in economic growth is negligible 322 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T The Project concentrated on the East Asian NIEs and their unique development experience Economic growth in these economies had been rapid and persistent moreover the benefits of economic devel opment had been broadly distributed throughout the societies The study looked for answers to particular questions What did the pro cess of economic development actually look like in these economies What if anything did the industrial and other economic policies of various governments contribute to the process of economic growth And was the experience of the NIEs in any way transferrable to the great majority of less developed countries that were falling farther behind rather than converging as economic theory predicted An swers to these questions would greatly facilitate World Bank decision making regarding the economic policies it should pursue in pro moting development Unfortunately the study and its report did not resolve the issue at least not to the satisfaction of proponents of alter native explanations of East Asian economic development Report on the Project The World Development Reports main finding was that there had been no East Asian miracle It concluded instead that the outstand ing success of the East Asian NIEs was due to the fact that these economies had pursued marketconforming economic policies and had fostered such economic fundamentals as high rates of savings investment education and prudent macroeconomic policy 30 These economies were successful because they conformed to the Solow model of economic growth based on factor accumulation Neither state intervention technological progress nor the theory of endoge nous growth the Report concluded had much to do with the rapid industrialization of these economies The Report included the follow ing specific conclusions 1 The East Asian economies followed prudent macroeconomic poli cies that kept government deficits down or even reduced accumu lated deficits kept inflation low and held foreign debt to modest levels Pursuing marketconforming economic policies and min imizing price distortions they got prices right by allowing domes tic prices to fall into line with international prices thereby en couraging industries with a natural comparative advantage to flourish 30 World Bank The East Asian Miracle Economic Growth and Public Policy New York Oxford University Press 1993 323 C H A P T E R T W E L V E 2 They maintained higher levels of savings and investment and had harder working and more skilled workers than did other LDCs For example 7 to 10 percent of Gross Domestic Product GDP went into investment this high rate of investment greatly facili tated rapid capital accumulation 3 The export push or exportled growth strategy of these econo mies was another reason for their success Focus on foreign mar kets promoted economic efficiency by keeping domestic prices closely in line with international prices and also accelerated intro duction of foreign technologies this then facilitated increased productivity The Report was very critical of the mystics the theory of endog enous growth and the idea of the developmental state Although it acknowledged that industrial policy and other forms of state interven tion might indeed have assisted the process of economic development its message was quite negative about the efficacy of state intervention The Report reached the following conclusions about the develop mental state 1 Industrial policies to promote particular sectors to determine the structure of the economy and thereby to accelerate development and productivity growth failed to explain the regions rapid growth State intervention was ineffective at best and counter productive at worst The major source of economic growth was capital accumulation which accounted for 60 to 70 percent of the growth whereas productivity growthtechnological input accounted for only about 30 percent of economic growth 2 Even without publicsector intervention market forces by them selves would have brought about the changes in industrial struc ture that were encouraged by governments 3 Government controls of financial markets the Report did point out had lowered the cost of capital and directed credit to favored sectors In light of the crisis of 1997 it is ironic that the Report had praised governments interventions in financial markets The World Development Report based on such findings described the theory or model of economic growth it used to explain East Asian economic success as functionalist and concluded that a developing country would be successful if it carried out specific mutually rein forcing functions The country had to find a way to rapidly accumu late such assets as human capital and capital investments It had to allocate resources efficiently And the country also had to achieve 324 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T rapid productivity growth by catching up technologically with ad vanced countries Although the Report gave some credit to effective state intervention in the economy this was played down due to con cern that LDCs with less competent andor more corrupt govern ments might attempt to use the Report to defend undesirable inter ventionist policies Ironically this project that began as an attempt by the Japanese to support their heterodox concept of an Asian model of economic development had been transformed into a defense of neoliberal orthodoxy and was hailed as a decisive vindication of neo liberal emphasis on the central role of the market in economic devel opment Criticisms of the Report Release of the World Development Report 1991 precipitated debate between its supporters and its critics 31 Although some neoclassical economists believed that the Report had erred in giving even minimal credit to East Asian governments for promoting rapid economic de velopment the most severe critics were proponents of the develop mental state who fiercely denounced it as blatantly ideological repre sentative of the laissezfaire position of the United States and the interests of private capital and as an effort to assuage growing West ern fears of competition from the rapidly industrializing countries of East Asia The following criticisms of the Report are especially note worthy The Reports emphasis on fundamentals suggests that economic growth is a fairly straightforward process of factor accumulation through private domestic investment education and exports Such a view is contradicted by the emphasis in the newgrowth models on the importance in the developmental process of imperfect informa tion increasing returns multiple equilibria path dependence selfre inforcing mechanisms historical lockins and other dynamic proper ties Critics argue strongly that growth processes are so complex that there can be no single explanation and that therefore the Reports considerable emphasis on factor accumulation was inappropriate Furthermore the Reports assumption that one can disentangle macro basics or fundamentalsinvestment education exports 31 Excellent evaluations of the Report are Albert Fishlow Catherine Gwin Stephan Haggard Dani Rodrik and Robert Wade Miracle or Design Lessons from the East Asian Experience Policy Essay no 11 Washington DC Overseas Development Council 1994 and Robert Wade Japan the World Bank and the Art of Paradigm Maintenance The East Asian Miracle in Political Perspective New Left Review 217 MayJune 1996 336 325 C H A P T E R T W E L V E from their micro foundations or supporting sociopolitical institu tions is deeply flawed Critics charge that fundamentals and institu tions cannot be separated from one another a high savings rate does not just happen but is the result of government policies and financial institutions When one factors in domestic policies and institutions the growth process becomes as complex as the new growth models suggest The authors of the Report deliberately played down their own findings regarding the important role of the state and of industrial policies in expediting rapid industrialization and they also neglected the crucial importance of public financial institutions in mobilizing savings evaluating projects managing risk monitoring managers and facilitating transactions For example although the Report ac knowledged that the most successful interventions by the state were the generous subsidies provided for manufactured exports critics of the Report charge that this important point was not accorded appro priate weight in the overall assessment of industrial policy In fact many of the marketfriendly policies praised by the Report such as export contests are actually examples of successful industrial pol icy 32 According to Report critics these contests proved a very effec tive method for the state to pick winners and thus to accelerate economic development Moral of the Tale A close reading of the World Development Report 1991 brings to mind the sage advice to literary critics set forth by D H Lawrence in his Studies in Classic American Literature 1964 33 The critic Lawrence admonished should always contrast the authors pro claimed moral with the moral of the tale itself as derived from a close reading of what the author had actually written The proclaimed moral of the Report is that state interventionism did not work how ever this moral is contradicted over and over again as the Report describes the successful policies actually followed by East Asian gov 32 Under the terms of these contests the government set forth certain conditions under which private firms competed for a valuable asset controlled by the government such as access to easy credit or foreign exchange The contest was organized so that the companies most likely to make successful use of the resource would win Thus an important criterion of success was export penetration of foreign markets The state it should be added also protected these sectors from imports and foreign direct invest ment 33 D H Lawrence Studies in Classic American Literature New York Viking 1964 326 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T ernments The Reports own assessment of the results strongly sug gests that state intervention and industrial policy were indeed vital factors in the economic success of the East Asian economies And there was a particularly excellent example of this in South Koreas export contests However the most basic weakness of the Report is its assumption that one can disentangle economic fundamentalsinvestment educa tion exportsfrom government development strategies and the over all society in which an economy is embedded The Report assumes that markets already exist and that economic development takes place in an economic and social vacuum This approach totally neglects the national system of political economyideology public institutions and private business practicesthat nurtures facilitates or frustrates the efficacy of markets Although there is no single East Asian model the countries economic and political institutions have set the East Asian economies apart and produced their economic fundamentals Would or could the economic fundamentals in East Asia have been put into place if there had been no developmental state or certain sociopolitical institutions That is unlikely The economic fundamen tals and the developmental state are closely interrelated Recognizing that the state and the fundamentals are integrated with one another and that economic fundamentals are anchored in their institutional context really supports the new growth theory It is clear that under standing economic development requires greater knowledge of a soci etys economic and political system than the Report indicates Al though the fundamentals provide the sufficient causes of successful economic development a wellfunctioning state is the necessary cause without an effective state the fundamentals would not even exist The Report erred by separating national economic policies from the fundamentals of these economies In these societies the state played a crucial role in accumulation of the factors emphasized by neoclassical economists The high savings rate the skilled and disciplined work force and large investments in education were all promoted by the state and did not just happen in response to the invisible hand of the market Moreover the Report relies excessively on Solowtype capital accumulation and ignores the importance of technological innovation and productivity growth Despite the argument put forth by some prominent economists the rapid and successful industrialization of these economies was due to both factor accumulation and technologi cal progress And both capital accumulation and productivity gains at least indirectly resulted from effective government policies 327 C H A P T E R T W E L V E This interpretation of the important part played by the develop mental state in the East Asian Miracle Project is supported in part by Paul Krugmans qualified vindication of the insights of early postwar development economics High development theory Krugman points out in Development Geography and Economic Theory 1995 was essentially correct in its emphasis on strategic complementarity with respect to investment and the problem of coordination 34 Early development economists recognized the need for coordinated invest ment to assure individual firms that other firms would make comple mentary or supportive investments The less developed countries eco nomic development theorists believed are at a decided disadvantage in their attempts to develop in the world of the strong How could these impoverished nations possibly develop industries capable of competing in world markets against such strongly established firms as Mitsubishi and General Motors Krugman argues that economies of scale and imperfect competition were missing from development theory and that without these two central ideas the theory and policies for economic development could not be sustained Development theorists did recognize the need for economies of scale at the plant level to give the less developed econ omy the comparative advantage it needed for economic development and international competitiveness However these theorists ignored the importance of scale economies and of imperfect competition at the national level 35 Development requires promoting strategic com plementarity through investment decisions supporting domestic firms until they achieve scale economies in their production and breaking the vicious cycle of poverty in which the LDCs have been trapped These tasks in turn require the guiding hand of a strong state Eco nomic development cannot be left to the market alone The state must play the key role in starting and managing the process of economic development Solow himself has written that neoclassical growth the ory tells us what determines the rate of economic growth but Solow does not tell us what gets growth started in the first place 36 34 Paul R Krugman Development Geography and Economic Theory Cambridge MIT Press 1995 35 Economists identify two types of economies of scale internal and external The former refers to the expansion of production by an individual firm and the resulting reduction of production costs The latter refers to expansion of an industry that makes possible greater specialization and other benefits that reduce the costs of the whole industry David W Pearce ed The MIT Dictionary of Modern Economics 4th ed Cambridge MIT Press 1992 12 36 Quoted in IMF Survey 16 December 1991 378 328 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T A few comments are in order about a highly controversial issue in economic development The initial success of the East Asian econo mies raised the important but unresolved issue of the relationship between development and democracy Successive American adminis trations following Milton Friedman although not necessarily know ingly have believed that development and democracy proceed hand in hand 37 During East Asias miracle period conservatives such as Nobel Laureate Gary Becker attributed the outstanding success of the East Asian economies to their democratic regimes subsequently conservatives blamed the problems following the 1997 financial crisis on the authoritarian nature of these political regimes From the other side of the intellectualpolitical spectrum Laureate Amartya Sen also argued that democracy and development complement or at least should complement one another 38 Other scholars are not convinced that there actually is a close connection between democracy and de velopment Robert Barro believes that the relationship of democracy and development is ambiguous and political scientist Atul Kohli after a careful review of the literature finds the connection equally elusive 39 A United Nations report released in April 2000 concludes that successful economic development requires good government a quality scarce in too many LDCs 40 The East Asian FinancialEconomic Crisis In the summer of 1997 the East Asian economies suffered a severe blow when a serious financial crisis and subsequently a much more general economic crisis brought the East Asian miracle to an abrupt halt By the summer of 2000 the stricken nations had rapidly recov ered from the crisis and its consequences Nevertheless it will take many years for the full social and political effects of this economic 37 Alberto Alesina and Roberto Peroti The Political Economy of Growth A Critical Survey of the Recent Literature World Bank Economic Review 8 no 3 1994 35171 38 Amartya Sen Development as Freedom New York Alfred A Knopf 1999 39 Robert J Barro Getting It Right Markets and Choices in a Free Society Cam bridge MIT Press1997 3 and Atul Kohli Democracy Amid Economic Orthodoxy Trends in Developing Countries Third World Quarterly 14 no 4 1993 67189 40 United Nations Development Program Overcoming Human Poverty UNDP Pov erty Report 2000 Included in the Reports definition of good government were free elections accountable and noncorrupt officials and ambitious national programs to alleviate poverty For LDC governments that tend to blame the rich countries for their economic difficulties the Report was not well received New York Times 5 April 2000 A11 329 C H A P T E R T W E L V E disaster to be fully understood Despite the inconclusive nature of this situation there has been an acrimonious debate over the explanation and meaning of the crisis The devastating setback of these miracle economies was immediately seized by many Western economists public officials and commentators as a convincing indictment of the developmental state it is clear they proclaimed that the East Asian economies should adopt the neoclassical development model based on free markets and minimal state intervention in the economy Many defenders of the East Asian developmental state model charged in turn that these economies were hapless victims of international fi nancial interests and the reckless policies of the Clinton Administra tion They contended that the developmental state model remains the most appropriate model for successful economic development According to the prominent Western crony capitalism interpreta tion the East Asian developmental state contained the seeds of its own destruction Those characteristics of the Asian model of eco nomic development that have been credited with the extraordinary success of these economies and their rapid industrialization were al leged to be the very ones that led to the financial crisis and to subse quent economic disaster Critics who have included high officials in the IMF and the American Treasury blamed the following flawed components of crony capitalism 1 the intimate ties among local politicians banks and industry 2 bank rather than stock market financing of economic development and 3 nontransparent or se cret financial arrangements involving governmentfavored businesses and banks This governmentmanipulated system encouraged ques tionable overinvestment especially in particular economic sectors by appearing to guarantee investors at least implicitly that their invest ments were not at risk In this way the developmental state created moral hazard that ultimately led to the crisis Proponents of the developmental state reject the above analysis and instead blame the crisis on the pernicious behavior of international financial markets As had happened many times before investors be came caught up in a frenzy of investment in these miracle econo mies The excitement surrounding the possibility of easy money caused investors to throw caution to the winds and ignore such obvi ous signs of impending trouble as the large number of shortterm liabilities that had been assumed by East Asian borrowers The huge investments in the region well above rational profit expectations were driven by the irrational euphoria of international investors In addition the premature liberalization of financial markets and capital accounts freedom of capital movements in these countries for 330 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T which the United States bears a large responsibility must be assigned much of the blame Thus the crisis was due to the irrational function ing of international financial markets along with certain irresponsible policies of the US Treasury And thus the controversy over the developmental state continues The Future of the Developmental State It is obviously too early to reach final conclusions regarding the future of the East Asian developmental state and the proper role for the state in the process of economic development 41 Yet there is strong evidence to support the idea that states must be very involved in economic development It is worth noting that several months prior to the crisis the World Bank had devoted its annual World Development Report 1997 to the crucially important issue of the political prerequisites of successful economic development 42 In this report titled The State in a Changing World the World Bank declared that economic develop ment is dependent on a societys getting its political as well as its economic fundamentals right Without the former such character istics of the latter as openness to trade and sound macroeconomic policies cannot work because social norms institutions and customs determine how economic inputs will be used and whether success will in fact be forthcoming 43 The Report rejected the implicit logic of the retreatofthestate doctrine that the minimal state is the optimal state a minimal state the Report pointed out can do no harm but a weak state can do no good either Neither statedominated nor stateless development constitute the means to successful economic development Although the Report refused to set forth a single recipe for state reforms worldwide it did provide a twopart strategy to forge an effective state capable of supporting rather than distorting economic develop ment 1 the state must match its activities with its capabilities and not attempt to do too much and 2 improvement of the states effec 41 Economists tried to assess these matters in the symposium The State and Eco nomic Development Journal of Economic Perspectives 4 no 3 summer 1990 42 World Bank World Development Report 1997 The State in a Changing World Washington DC World Bank 1997 43 As Dani Rodrik has argued contrary to the impression given by some economists trade by itself will not lead to economic development Dani Rodrik The New Global Economy and Developing Countries Making Openness Work Washington DC Overseas Development Council 1999 331 C H A P T E R T W E L V E tiveness requires vigorous public institutions and includes restraints to check corrupt behavior by public officials 44 In the same report the World Bank recognized that economic de velopment entails much more than solution of technical economic problems and is at its core a social and political problem In its early years the World Bank had followed the prescriptions of economists that economic development results when crucial economic and techni cal obstacles have been overcome During the 1980s under the reign of neoliberalism and the Washington Consensus the doctrine of structural adjustment assumed that economic reforms and elimina tion of state interventionism would release economic forces that would speed development The Bank and its economists have since learned to appreciate that more than economic fundamentals are necessary to achieve economic development The World Development Report 1997 returned to a truth first set forth in 1952 by Moses Abramowitz a pioneer in the study of economic growth 45 The fundamental requirement for economic development Abramowitz wrote was social capacity Economic development is not a technical economic problem involving factor accumulation and getting the fundamentals right it is a social process that cannot be completed unless the state creates economic institutions fosters social behavior and pursues policies favorable to economic development The thennew formal modeling of economic growth Abramowitz pointed out deals with the immediate source of economic growth and not with the social and other factors behind the immediate fac tors His emphasis on the social and political aspects of economic development suggested that there was no single best way for a society to foster economic development At the turn of the century efforts to understand the task of eco nomic development again emphasized the need for a national devel opment strategy 46 Official thinking about economic development has 44 World Bank World Development Report 1997 The State in a Changing World A valuable history of the central role of states in economic development is Linda Weiss and John M Hobson States and Economic Development A Comparative Historical Analysis London Polity Press 1995 45 Abramovitz first set forth his notion of social capacity in Thinking About Growth and Other Essays on Economic Growth Cambridge Cambridge University Press 1989 a restatement of his position is Following and Leading in Horst Hanusch ed Evolutionary Economics Applications of Schumpeters Ideas New York Cam bridge University Press 1988 339 46 Dani Rodrik in his book The New Global Economy and Developing Countries argues that a country needs a strategy for domestic investment and a sound framework for resolving political conflict Also see Rodrik Getting Interventions Right How South Korea and Taiwan Grew Rich Economic Policy April 1995 55107 332 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T in fact passed through several distinct stages In the 1960s the World Bank regarded economic development as a matter of solving a num ber of discrete technical problems regarding efficient use of resources and capital transfers In the 1970s and early 1980s emphasis was on trade liberalization and elimination of market dislocations caused by government intervention structural adjustment Later in the 1980s the focus shifted to macroeconomic adjustment intended to eliminate inflation and macroeconomic instability the Washington Consensus In the 1990s the World Bank and many experts began to appreciate that development requires transformation of the society Joseph Stig litz an economists economist is purported to have conceded at a meeting that economists are beginning to understand that develop ment is complex and that there is more to development than trade liberalization and macroeconomic adjustment Similar lessons are ap plicable to the problems facing transitional economies Transitional Economies The transition of the former command or communist economies of China the Soviet bloc and elsewhere to democratic marketbased societies is one of the most important issues of the postCold War era I use the term transition advisedly As Stephen Holmes has pointed out transition suggests that these economies are on a known and predictable trajectory from communism to democratic capital ism 47 The truth is that no one really knows what economic political and other factors led to the overthrow of communism and even less is known about the forces at work in these postcommunist societies or about the direction in which economic and political forces are pro pelling them Theories and speculations of various kinds abound as scholars intellectuals and public officials attempt to provide an over all explanation of this extraordinary and historically unprecedented situation Yet as Holmes suggests no guidelines can help us to deter mine where these unfortunate postcommunist societies are heading democracy fascism or even a return to communism Nevertheless despite its misleading implications I shall follow convention and use the term transitional societies The mere size of the transition problem is overwhelming The mag nitude and diversity of the swath of countries from the Baltic to the Balkans and from Eastern Europe across the steppes of central Asia to the Pacific Ocean defy comprehension The twentyseven or more 47 Stephen Holmes Cultural Legacies or State Collapse Probing the Postcommunist Dilemma in Michael Mandelbaum ed Postcommunism Four Perspectives New York Council on Foreign Relations 1996 2276 333 C H A P T E R T W E L V E countries involved excluding China contain more than 400 million people Many of these countries are mired in economic and political chaos with declining economies and corrupt governments The end of communism has taken many different forms and each different form strongly influences the path of the transition Also consideration of the transition issue is greatly compounded by the fact that individual countries are in very different economic and political situations At one end of the spectrum is Russia which has sought to create simulta neously both a democratic and a market economy At the other end is China where an effort is being made to combine a highly authori tarian political regime with a markettype economy In between these extremes are numerous unfortunate countries with a host of social economic and political problems There is no historical experience on which one can draw for in sights nor are there economic political or other social theories on which one may rely for guidance and economics has failed miserably as a guide The transition problem is novel in the sense that the world has never before experienced the transition from one type of highly industrialized economy to a different type of highly industrialized economy Although the rise of capitalism in the modern period pro vides some lessons such as the need for an entrepreneurial class and a nonoppressive state the implications of these lessons for a developed economy in transition are not clear The former communist countries must first tear down corrupt and inefficient structures before they can begin to build new effective and publicly responsible economic and political institutions Therefore this discussion of the transitional economies must be sketchy as well as tentative Transition Theories Following the collapse of communism every formerly communist country in East Europe including Russia suffered severe recession deindustrialization and economic chaos by one estimate recession reduced by onequarter the national product of Eastern Europe 48 These economic troubles set back reform and in some cases resulted in a retrenchment of the reform effort More generally recession and its aftermath had a profound negative impact Reform has been rec ognized as much more complicated and difficult than most econo 48 Kazimierz Z Poznanski The PostCommunist Transition as an Institutional Dis integration Explaining the Regional Economic Recession unpublished and undated Janos Kornai Transformational Recession Main Causes Journal of Comparative Economics 19 no 1 August 1994 3963 334 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T mists public officials and others had anticipated 49 Scholars and oth ers have set forth different explanations of what went wrong One explanation is based on the doctrine of neoliberalism another is the theory of cultural legacy and yet another emphasizes the crisis of governance Although each of these theories provides insights into the nature of postcommunist societies the third is the most compelling explanation The neoliberal convergence explanation is strongly influenced by the neoliberal ideas and perspective on structural adjustment and in cludes a minimal role for the state in the economy and heavy reliance on the market 50 According to this position the postcommunist reces sion was an inevitable consequence of the transition from a command to a free market economy In a communisttype economy a number of serious hidden problems exist that only become known following the collapse of communism For example a major aspect of the tran sition problem is unwanted production Under a planned economy firms produce a large number of goods that consumers are not inter ested in buying The shift from a selleroriented economy to a buyer oriented or market economy takes time and not enough time has yet elapsed to solve the resultant problems For example it takes time to create the type of middle class essential to the functioning of a markettype economy It is the nature of reforms this position argues that matters get worse before they get better According to the cultural legacy explanation the bad habits and mentalities of the past change slowly Communism created passive and dependent peoples Communist culture molded societies charac terized by duplicity disinformation extreme selfinterest reliance on personal connections and avoidance of any responsibility for ones actions In addition the triumph of communism suppressed issues traditions and problems that resurfaced when communism disap peared and that have made the transition process more difficult Among these vestiges from the past the revival of nationalism and ethnic conflict has proved particularly important The collapse of Yu goslavia into internecine war exemplifies dramatically just how ex treme the possible problems can be The most valuable explanation for the severe problems of the post 49 Joseph Stiglitz Quis Custodiet Ipsos Custodes Challenge 42 no 6 November December 1999 2667 50 A powerful critique of this position is in Alice H Amsden Jacek Kochanowicz and Lance Taylor The Market Meets Its Match Restructuring the Economies of East ern Europe Cambridge Harvard University Press 1994 335 C H A P T E R T W E L V E communist countries is the crisisofgovernance explanation 51 For a number of reasons the political elites of Eastern Europe engineered the collapse of the state as rapidly as possible and before society was ready for such drastic change There had been uncritical acceptance of the neoliberal doctrine of the minimal state and the important functions of the state in democratic marketoriented societies were not really understood Another reason for abandoning the state as quickly as possible was the intense fear of a communist resurgence elimination of the state bureaucratic apparatus would make a return to power by the communists much more difficult Another cause of the collapse of the state was the extraordinarily rapacious and corrupt behavior of public officials These officials had an interest in elimina tion of the state and through one means or another they and their allies including criminal elements in Russia grabbed state assets for selfenrichment Political elites in most postcommunist societies for sook the commonweal for shortterm private advantage The Transition Record Application of the three transition explanations to the experience of postcommunist society supports the crisis of governability or col lapseofthestate explanation In general terms the transition prob lem involves implementation of several complex and difficult tasks New public institutions must be established and old institutional structures reformed or eliminated while rules and regulations re quired for a markettype economy must be established Privatization of stateowned economic sectors and change of ownership of the means of production from public to private owners must be accom plished The inefficient statemanaged economic structure must be liq uidated and privately owned firms that can adapt to a markettype economy must be installed Marketization must also be implemented the command or plan system of communism must be replaced by the price mechanism in which economic decisions and the direction of the economy are determined by the response of individuals and firms to changes in relative prices Beyond these economic reforms is the far more demanding challenge of creating a new civic culture of pub lic virtue as well as a national sense of social responsibility Without such a moral or psychological change in the sentiments of the people 51 See Holmes Cultural Legacies or State Collapse p 50 Holmess position is supported by Andrei Shleifer and Daniel Treisman Without a Map Political Reform in Russia Cambridge MIT Press 2000 336 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T the goal of a successful transition to a democratic capitalist system will never be achieved Institutional Reform The experience of institutional reform has dif fered greatly across Eastern Europe At one extreme is Poland which has moved slowly but has implemented a number of important re forms at the other is Bulgaria which has made few efforts to trans form its economy However the task of institutional reform every where has been strongly influenced by neoliberalism and its emphasis on the market It is not excessive to state that the guiding idea of transition was that private enterprises were considered to be key agents of economic and political change in Eastern Europe and other former communist countries Institutional transformation was be lieved to entail the simple substitution of the market for the state The market in turn would lead to creation of impersonal public insti tutions and a civic culture required for the proper functioning of a market economy The collapseofthestate position however argues that the reform ers eliminated a state apparatus that was necessary for managing the economy and did not replace it with public and private institutions required for an effective marketmanaged economy The greater the reform or state withdrawal eg in Russia and East Germany the greater the depth of the postcommunist crisis According to this position it was essential that the state manage the transition from communism and make a market economy work An effective and ac countable state must elicit voluntary cooperation from its citizenry if it is to solve collective problems It must also rebuild the infrastruc ture of the society laid waste by communism education the judicial system and institutions concerned with energy banking health and other necessities State policy must establish the rules governing the market economy and guaranteeing private property rights policies should be fair and consistent The neoliberalinspired transition pro cess produced many corrupt and ineffective states Without an effec tive and responsible state successful transition could not take place Privatization The purpose of privatization in Eastern Europe was to transfer stateowned property to the private sector For reasons that I have already discussed sellingoff of state assets was carried out as rapidly as possible and with many disastrous consequences In a num ber of countries there was a rush to create an indigenous middle class that would ensure political stability and strongly resist the return of communism However the various types of privatization schemes 337 C H A P T E R T W E L V E such as property vouchers and sales to workers were abject failures or at least resulted in very serious problems 52 In many countries state property was sold to former communists corrupt public officials and political favorites at very low prices privatization in Russia even spawned a powerful criminal class Although it is too soon to make a definitive judgment on privatization at least one can say that it failed to create the strong middle class desired by many reformers It also constituted one of the most significant redistributions of wealth in world history In addition to the speed of privatization and prevalence of corrup tion as obstacles to successful privatization were a low level of savings and serious troubles within the banking systems Reforms had weak ened the financial position of local firms and of the banking systems many countries suffered from a liquidity crisis and potential investors in these countries lacked sufficient capital to purchase those busi nesses and factories put up for quick sale As a consequence foreign firms especially German purchased a substantial portion of the assets sold The resulting level of foreign ownership is quite high particularly in Poland the Czech Republic and Hungary few coun tries have so many business enterprises and important industries in foreign hands Kazimierz Poznanski has estimated for example that 70 percent of Hungarian industry and banking are foreignowned 53 This situation has both benefits and possible costs for the host socie ties On the one hand foreign ownership has meant a rapid inflow of needed capital technology and knowhow On the other it has fos tered a highly oligopolistic economic structure that could result in exploitation and it raises the fear of being drawn into a German sphere of economic domination Marketization The principal goal of transition is to change from a command to a market system based on the price mechanism This important structural change entails a move from a sellers to a buy ers market and enforcing a hard budget constraint through priva tization and elimination of such government support mechanisms as subsidies to favored enterprises 54 Such reforms constituted according to the neoliberal agenda incentives to encourage profitmaximizing market behavior by all economic actors Incentives would lead to a 52 The various methods to privatize the economy are briefly discussed in Oleh Harvy lyshyn and Donal McGettigan Privatization in Transition Countries Lessons of the First Decade Washington DC International Monetary Fund 1999 79 53 Poznanski The PostCommunist Transition 54 Harvylyshyn and McGettigan Privatization in Transition Countries 2 338 T H E S T A T E A N D E C O N O M I C D E V E L O P M E N T shift from old to new and more efficient economic activities and to restructuring labor rationalization new product lines etc of those firms not eliminated by the shift to a marketbased system based on private enterprise Released economic forces would then transform postcommunist economies to markettype economies The necessary conditions for marketization have not been fully achieved The rules laws and regulations necessary to a wellfunc tioning market economy have been put in place only partially Privati zation has been very uneven throughout the region and has been dis torted by corrupt behavior in many instances Many government support mechanisms are still in place and backtracking on privatiza tion has appeared in response to public protests A large part of eco nomic activity is in fact still in state hands In addition withdrawal of financial support and protection through elimination of state sub sidies and drastic lowering of trade barriers ruined many enterprises and set back the process of marketization The overall impact of these developments has been extraordinarily harmful In effect partial and uneven reform has created what Joel Hellman has called a winner take all politics 55 The beneficiaries of partial reform who were able to take advantage of the absence of a competent honest state and to profit from the spoils of privatization have become powerful oppo nents of further economic reform This situation in some countries has resulted in a new class structure of winners and losers that could make further reform much more difficult The postcommunist experience has taught that creation of an effec tive market economy requires a state with the power to establish and enforce the rules of the market In some countries especially Poland and Hungary considerable progress toward a market economy based on private enterprise and impersonal rules has been made Too many postcommunist countries however have failed to create a civic cul ture based on mutual trust and public responsibility a culture that can support a markettype economy It is illusory to speak of a transi tion because it is anyones guess where these postcommunist countries are really heading Conclusion As this is written in the year 2000 the international community has not yet come to terms with the immense problems of economic devel 55 Joel S HellmanWinner Take AllThe Politics of Partial Reform in Postcommu nist Transitions World Politics 50 no 2 January 1998 339 C H A P T E R T W E L V E opment Whether or not a development regime is a possible or appro priate solution may be moot In an era of neoliberalism with stress on the free market a development regime is out of the question On the other hand free trade and economic openness do not by them selves constitute an adequate solution to the problem of underdevel opment or to the problems of the transition economies A compro mise must be found somewhere between the two extremes of abandonment of neoliberalism and total reliance on the market Jef frey Sachs has made an important start in this direction with his argu ment that the longterm solution to LDC problems will require that the fundamental problems that they face be solved by the interna tional community tropical and arid agriculture must be improved a similar point was made long ago by Arthur Lewis science and tech nology must be mobilized for development purposes and major prob lems of environmental degradation and public health HIV malaria and other tropical diseases must be reduced or better eliminated 56 Solving such problems would benefit rich and poor alike 56 Sachs on Development The Economist 14 August 1999 1720 340 CHAPTER THIRTEEN The Political Economy of Regional Integration T HE MOVEMENT toward economic regionalism or regional trade agreements RTAs which accelerated in the mid1980s pro duced a significant impact on the shape of the world economy 1 This new regionalism differed in fundamental respects from an earlier re gional movement in the 1950s and 1960s it had much greater sig nificance for the world economy The earlier movement whose only survivor is the European Union was limited largely to trade and just a few other areas The new regionalism is more global in scope and involves integration not only of trade but also of finance and foreign direct investment Also the goal of the movement toward regional integration in Western Europe became political unification as well as creation of a single unified market In Western Europe and elsewhere trade has become increasingly regionalized and this development has caused concern that the international economy may be moving in the direction of regional economic blocs The European Single Market Act 1986 triggered the new region alism and stimulated development of other similar efforts In the early 1980s European reticence to join the Americaninitiated Uru guay Round of trade negotiations fear in the United States that Eu rope was turning inward and impatience with the slowness of the General Agreement on Tariffs and Trade GATT negotiations led to the American decision to support North American economic regional 1 The writings on economic regionalism and preferential trading arrangements have greatly expanded in recent years Among the numerous writings on this subject the following are especially noteworthy Jagdish N Bhagwati and Arvind Panagariya eds The Economics of Preferential Trade Agreements Washington DC AEI Press 1996 Richard Gibb and Wieslaw Michalak eds Continental Trading Blocs The Growth of Regionalism in the World Economy New York John Wiley 1994 Vincent Cable and David Henderson eds Trade Blocs The Future of Regional Integration London Royal Institute of International Affairs 1994 Paul De Grauwe The Economics of Monetary Integration 2d rev ed New York Oxford University Press 1994 Jaime De Melo and Arvind Panagariya eds New Dimensions in Regional Integration New York Cambridge University Press 1995 Miles Kahler Regional Futures and Transat lantic Economic Relations New York Council on Foreign Relations 1995 and Jef frey A Frankel Regional Trading Blocs in the World Economic System Washington DC Institute for International Economics 1997 341 C H A P T E R T H I R T E E N ization Once launched the slow and drawnout Uruguay Round as well as the regional movements in Western Europe and North America undoubtedly also contributed to the spread of regional trade agreements elsewhere in the world Many nations fearing that the Round would never succeed or that they would be shut out of other regional arrangements initiated regional efforts and regional trade agreements proliferated By the late 1990s there were approximately 180 regional agreements and almost all members of the World Trade Organization with the notable exception of Japan Hong Kong and Korea were included in one or more formal regional arrangements Previously initiatives toward development of regional free trade areas had been followed by new rounds of multilateral trade negotia tions The United States had responded to the Treaty of Rome 1957 and the subsequent creation of the European Community by initiating multilateral trade liberalization within the GATT the Kennedy Round 19631967 of trade negotiations was a response by the United States to the creation of the European Community Common Market and the Tokyo Round 19731979 a response to the first enlargement of that Community However the multilateral American approach to the movement toward European integration changed in the 1980s When it became clear that the Single Market Act in the mid1980s could create a united and possibly closed West European market the United States followed Canadas lead and shifted its pol icy toward development of a regional arrangement of its own the North American Free Trade Agreement NAFTA In Pacific Asia largely in response to European and North Ameri can regional developments Japan intensified its own efforts to create and lead a regional economy As more and more developing countries liberalized their economies unilaterally to achieve greater efficiency and abandoned importsubstitution strategies in favor of a greater emphasis on exportled growth they too began to perceive the advan tages of regional initiatives that would promote economies of scale for their industries and provide some counterbalance to regionaliza tion in Europe and in North America This expanding movement to ward regional integration can be characterized as a response to what political scientists call a security dilemma in which each regional movement attempts to enhance its own bargaining position visavis other regions Albert Fishlow and Stephan Haggard have made a useful distinc tion between marketdriven and policydriven regional integration certainly both political and economic considerations are involved in 342 P O L I T I C A L E C O N O M Y O F R E G I O N A L I S M every regional movement 2 However the relative importance of eco nomic and political factors differs in each Whereas the movement toward integration of Western Europe has been motivated primarily by political considerations the motivation for North American re gionalism has been more mixed and Pacific Asian regionalism has been principally but not entirely marketdriven Attainment of such political objectives as ending FrenchGerman rivalry and creating a political entity to increase Europes international standing and strengthen its international bargaining position has been of vital im portance in European integration North American regionalization on the other hand has been primarily marketdriven establishment of the free trade area reflected the natural integration of the three North American economies Canada Mexico and the United States by market forces However some political motives such as strength ening North Americas position visavis Western Europe and reduc ing illegal Mexican migration into the United States have also been factors And in Pacific Asia although market forces have been the most important factors in integration of the economies political con siderations and Japanese policies have also played significant roles 3 Moreover even though economic regionalism has become a univer sal phenomenon regionalism has also assumed quite diverse forms 4 In addition to the differing mix of political and economic goals re gional arrangements vary in their institutional form For example 2 Albert Fishlow and Stephan Haggard The United States and the Regionalization of the World Economy Development Centre Documents Paris OECD 1992 3 Although the Asia Pacific Economic Cooperation APEC organization could be considered an example of regional integration its achievements have been quite modest 4 Ali M ElAgraa ed with contributions The Economics of the European Commu nity London Harvester Wheatsheaf 1994 provides a useful discussion of the various types of regional integration These arrangements include the following in order of the stage of integration 1 Free trade area Members eliminate all trade restrictions against each others goods an example is the North American Free Trade Agreement NAFTA 2 Customs union Although similar to a free trade area participating coun tries adopt uniform tariffs and other trade restrictions visavis countries outside the union the most prominent example was the European Economic Community or Com mon Market created by the Rome Treaty 1957 3 Common market Extends a cus toms union to include the free movement of the factors of production goods services people capital 4 Economic union The highest form of economic integration incor porates the previous stages of integration and adds monetary and fiscal policy harmoni zation the only example is the movement toward European economic integration 5 Political Union Moves beyond economic union to supranational decision making be yond the purely economic a political union is the ultimate goal of the movement to ward European unity 343 C H A P T E R T H I R T E E N whereas Western Europe is attempting to create an integrated politi caleconomic entity has erected an external tariff and has become highly institutionalized Pacific Asian regionalization has no external tariff a very low level of institutional development and every econ omy in the region has retained high tariffs North American regional ism stands somewhere between the other two The North American Free Trade Agreement created a free trade area without an external tariff does not have a common market and has only a few formal institutions The movement toward greater unity as Europe seeks to achieve both economic and political integration is the only example of what scholars call deep regional integration The diversity of regional arrangements makes broad generaliza tions and overarching theories or explanations of regionalism impos sible One cannot confidently assess these regional efforts or predict their effects upon the world economy It is nonetheless desirable to present a summary and critique of the principal attempts by econo mists and political scientists to develop theories or explanations re garding economic and to a lesser extent political regionalism In gen eral economists have been interested in the welfare consequences of regional arrangements for members and nonmembers and political scientists have been more concerned with ways to explain economic and political integration While writings thus far have provided im portant insights into many aspects of economic regionalism they leave many questions unanswered 5 Economic Theories Integration of formerly selfcontained economic areas into larger eco nomic entities has been important in modern history The modern era has been characterized by integration of small and relatively distinct territories into larger nationstates and into national economies sur rounded by trade barriers Despite this process of economic integra tion when Fritz Machlup conducted an extensive review of the eco nomic literature in 1976 he learned that prior to 1947 economists 5 It is worth noting that the subject of political fragmentation has received very little attention from scholars of political economy One exception is Patrick Bolton and Gerard Roland The Breakup of Nations A Political Economic Analysis April 1995 unpublished 344 P O L I T I C A L E C O N O M Y O F R E G I O N A L I S M had written little about economic integration 6 Such neglect is star tling because of the obvious importance of the integration of national markets to the nature and evolution of the world economy Beginning with the European movement toward economic integration in the early postWorld War II period the economics profession began to pay more attention to international integration Yet theoretical results have been sparse and have not significantly advanced our understand ing of the actual process of economic integration or of its conse quences In fact the subject of economic integration remains largely empirical rather than theoretical 7 The principal approaches that economists have taken in their ef forts to explain regional integration or free trade areas arise from neoinstitutionalism and the new political economy The new institu tionalism approach assumes that international including regional in stitutions such as those of Western Europe are established to over come market failures solve coordination problems andor eliminate other obstacles to economic cooperation These institutions create in centives for states to cooperate and through a variety of mechanisms to facilitate such cooperation Although the new institutionalism pro vides valuable insights it does not consider the political reasons for regional arrangements The new political economy explanation em phasizes interest group politics and the distributive consequences of economic regionalism it assumes that such regional trade arrange ments as customs unions and free trade agreements have significant redistributive consequences that are usually harmful to nonmembers and create both winners and losers among the members themselves Indeed economists frequently explain economic integration as result ing from efforts of domestic interests to redistribute national income in their own favor This approach provides important insights into the domestic politics of economic integration but fails to explain the costly efforts by Europeans to achieve regional integration 6 Fritz Machlup ed Economic Integration Worldwide Regional Sectoral London Macmillan 1976 63 Studies by economists on economic integration include Bela Balassa The Theory of Economic Integration Homewood Ill Richard D Irwin 1961 and Peter Robson The Economics of International Integration London Allen and Unwin 1987 Two pioneering studies of economic integration are W M Corden Monetary Integration Essays in International Finance no 93 Princeton University Department of Economics International Finance Section April 1992 and J E Meade H H Liesner and S J Wells Case Studies in European Economic Union The Me chanics of Integration London Oxford University Press 1962 7 A discussion of economic theories of integration is found in Bhagwati and Panaga riya eds The Economics of Preferential Trade Agreements 345 C H A P T E R T H I R T E E N The Marxist theory of economic and political integration is another economic approach to an explanation of integration According to Belgian economist Ernest Mandel economic integration in general and the movement toward European economic and political integra tion in particular are explained by the efforts of transnational capi talist classes to increase the scale of capital accumulation 8 Over the course of modern history the requirements of capital accumulation have driven the world toward ever larger economic and political enti ties According to this point of view technological developments and international competition are forcing the dominant European capital ist class to overthrow the narrow confines of national capitalism and forge a regional economy that will strengthen the international com petitiveness of European capitalism However as I shall point out later economic determinism omits certain important political and strategic motives responsible for economic integration Economic theories do not provide a satisfactory explanation of eco nomic integration This is because economic analysts generally as sume that a political decision has been made to create a larger eco nomic entity and that economists need only analyze the welfare consequences of that decision and concern themselves with just a few aspects of the process of economic integration Another theoretical subject of interest to economists has been the theory of an optimum currency area OCA this theory specifies the conditions necessary for establishment of a common currency within an economic region This theory is of special relevance to the effort to achieve the Euro pean Economic and Monetary Union EMU There is also a small literature on the optimum regionalization of the world economy and attention is given to comparison of the political and economic consequences of a world containing two regionalized economies with the consequences of a world of three or more integrated regions An important body of economic literature deals with the welfare consequences for nonmembers of such regional arrangements as cus toms unions the European Common Market and of free trade areas NAFTA The classic work on the welfare consequences of regional trade agreements is Jacob Viners The Customs Union Issue 1950 a study stimulated by growing concerns in the United States and else where about the accelerating movement toward a Western European common market 9 Prior to Viners analysis the conventional wisdom 8 Ernest Mandel Europe versus America Contradictions of Imperialism London NLB 1970 9 Jacob Viner The Customs Union Issue New York Carnegie Endowment for Inter national Peace 1950 346 P O L I T I C A L E C O N O M Y O F R E G I O N A L I S M of the economics professionbased on the theory of comparative advantagehad been that regional agreements were beneficial to members and nonmembers alike and that they produced much the same consequences as did global trade liberalization In other words the preViner position was that the economic gains to both members and nonmembers were similar to those produced by free trade and included the benefits of specialization improved terms of trade greater efficiency due to increased competition and increased factor flows among members In his study Viner not only challenged this optimistic assumption but also analyzed customs unions implications for nonmembers Viners analysis pointed out that a common external tariff would have tradediverting as well as tradecreating effects The initial or static consequences of an external tariff say around the European Common Market would divert trade from foreign suppliers to sup pliers located within the Common Market However as Viner also pointed out the longterm or dynamic effects of a common market would lead to creation of a larger and more wealthy European market that would benefit not only local firms but also the markets external trading partners Whether the tradediverting or the tradecreating effects of a customs union would ultimately predominate Viner con cluded was an empirical question that could be answered only from actual experience Likewise the welfare consequences for nonmem bers could not be determined theoretically but only by observing the specific actions and policies of the European Economic Community or other regional arrangements Viners pioneering analysis has been extended and modified by sub sequent research yet his insight into the basic indeterminacy of the welfare effects of economic regionalism remains valid 10 Indeed Vin ers conclusions have been supported by a report in 1997 from a group of international experts 11 Although these experts could draw upon theoretical developments and actual experience accumulated subsequent to Viners study they too concluded that neither eco nomic theory nor empirical evidence can inform us whether or not 10 See Alfred Tovias A Survey of the Theory of Economic Integration in Hans J Michelmann and Payayotis Soldatos eds European Integration Theories and Ap proaches Lanham Md University Press of America 1994 11 Jaime Serra et al Reflections on Regionalism Report of the Study Group on International Trade Washington DC Carnegie Endowment for International Peace 1997 See also Paul J J Welfens Economic Integration Theory in Desmond Dinan ed Encyclopedia of the European Union Boulder Colo Lynne Rienner 1998 15358 347 C H A P T E R T H I R T E E N a specific regional arrangement will harm nonmembers No general conclusions can be drawn because of the very different and specific aspects of each regional arrangement Indeed economists answer the question of whether regional arrangements will lead to trade diver sion or trade creation with the classic answer of economists and other scholars to difficult issues more research is needed Since Viners early work the new trade and growth theories have strongly influenced economists thinking about regional integration Whereas Viners analysis was based on the neoclassical theories of trade and economic growth that assumed perfect competition con stant returns to scale and diminishing returns new thinking about economic integration is based on economies of scale and other favor able consequences of integration such as R D spillovers within the region This means that firms within a regional arrangement can gain competitive advantages from which firms outside the arrangement are excluded This theory implies that countries could and probably would support regional trade barriers and trade diversion so that firms within the region would have exclusive access to technological advances economies of scale and other advantages External barriers could also protect such firms from external competition and enable them to achieve economies of scale and international competitiveness as well Regional trade barriers could enhance the bargaining position of local firms and governments in their dealings with outside firms and governments Evidence suggests that such strategic advantages of economic regionalism have played a rolebut not a determining rolein the movement toward European integration Political Theories Political scientists have had an interest in political and economic inte gration for a relatively long time but before the movement toward European unity no one attempted to formulate general theories or explanations of regional integration 12 Political scientists have empha sized institutional solutions to the problems of war and international political instability and have focused on the idea of federalism and political integration of the world From the early postwar period on the thinking of those interested in integration has been influenced 12 An important volume on the ideas of political scientists regarding economic and political integration is Edward D Mansfield and Helen V Milner eds The Political Economy of Regionalism New York Columbia University Press 1997 See also An drew Moravcsik Integration Theory in Desmond Dinan ed Encyclopedia of the European Union Boulder Colo Lynne Rienner 1998 27891 348 P O L I T I C A L E C O N O M Y O F R E G I O N A L I S M by federalism neofunctionalism neoinstitutionalism intergovern mentalism and realism Federalism Throughout modern history idealists have set forth schemes to solve the problem of war by building federalist institutions to which parties will consciously and voluntarily surrender their political autonomy and sovereign rights In the twentieth century Woodrow Wilsons proposal for a League of Nations and the later establishment of the United Nations inspired additional federalist solutions to prevent an other great war Following World War II the World Federalist move ment whose appeal arose from its emphasis on persuasion convert ing public opinion and building of institutions expanded Although the federalist idea had some influence on the movement toward Euro pean integration it appealed most of all to those interested in the global level Despite its intellectual appeal federalism has never proved to be a successful route to political integration and its successes have been achieved only under unusual political circumstances The few exam ples of successful federal experiments have been motivated primarily by national security concerns Indeed the two most successful federal republicsSwitzerland and the United Stateswere created in re sponse to powerful external security threats And in the United States full political and economic integration were attained only after the victory of the North over the South in the Civil War The German federalist state resulted from conquest by one nation Prussia of other German political entities Historically political integration of independent political entities has resulted from military conquest or dynastic union and neither of these methods will necessarily lead to creation of an integrated economy Functionalism and Neofunctionalism The theory of neofunctionalism was very influential in the 1950s and 1960s Closely associated with the writings of Ernst Haas neofunc tionalism is the most important effort by political scientists to explain political integration in general and European political integration in particular 13 Drawing upon the social sciences Haass theory of neo functionalism elaborated and extended by his students and other scholars argued that economic technological and other develop 13 Ernst Haas The Challenge of Regionalism International Organization 12 no 3 1958 44458 349 C H A P T E R T H I R T E E N ments during the twentieth century have driven peoples and nation states toward peaceful economic and political integration at both the regional and global levels The theory of neofunctionalism had its roots in preWorld War II functionalist theory that had appeared in response to the failure of the League of Nations to maintain the peace after World War I Col lapse of the League made people aware that something more than voluntary federalism was needed to ensure world peace The British social democrat David Mitrany took up this challenge and systemati cally set forth his functionalist theory as a solution to the problem of war in his highly influential monograph A Working Peace System and other writings 14 According to Mitrany modern economic technolog ical and other developments made political integration of the world possible and necessary Technocratic management of an increasingly complex and integrated global economy and social system had be come imperative The problem of war could be solved and the warprone system of nationstates could be escaped Mitrany argued through interna tional agreements in such specific functional or technical areas as health postal services and communications Even though the politi cal system remained fragmented into jealous and feuding nation states such functional and technical international institutions were feasible because the world in the twentieth century had become highly integrated both economically and physically by advances in commu nications and transportation As functional international institutions succeeded and promoted social and economic welfare they would gain legitimacy and political support and would over time triumph over the nationstate Mitrany assumed that an economically and technologically inte grated world had given rise to many complex technical problems that individual competing states could not deal with effectively If func tional problems in the areas of health and postal services were to be solved nationstates should in their own selfinterest establish international organizations to carry out the required activities Then as the new organizations proved their effectiveness in dealing with various technical problems states would delegate more and more tasks to international institutions As new functional arrangements were put into place the realm of independent political action and hence also of international conflict would become more and more circumscribed In time states would learn the advantages of peaceful 14 David Mitrany A Working Peace System Chicago Quadrangle 1966 350 P O L I T I C A L E C O N O M Y O F R E G I O N A L I S M cooperation and the importance of political boundaries would di minish Political integration of the world would thus result from eco nomic and other forms of international cooperation Inspired by Mitranys insights Ernst Haas developed what he called neofunctionalism and applied this theory to both interna tional institutions and the process of European integration 15 Drawing on literature in social science Haas produced The Uniting of Europe 1957 and Beyond the NationState 1964 Like Mitrany Haas be lieved that modern democratic and especially welfare states required rational management of the economy and centralized technocratic control However for Haas Mitranys functionalism was too unso phisticated politically and lacked a theory of how integration actually took place Whereas Mitrany had emphasized the deliberate actions of national leaders to create international institutions Haass focus was on domestic interest groups and political parties promoting their own economic selfinterest He also stressed the unintended conse quences of previous integration efforts which he called spillover as groups realized that integration could serve their selfinterest there would automatically be spillover from one area of integration to an other In time the process of spillover would lead to political cooper ation and a transnational political community favoring more exten sive and centralized regional or international governing mechanisms Haas was not especially interested in the reasons for initiating inte gration efforts however once an integration effort had been launched Haas foresaw pressures for further integration He expected that so cial and economic groups would demand additional economic inte gration and that that would create new political actors interested in and ready to promote further integration Political integration would be carried out by the actions of both domestic interest groups and international civil servants or entrepreneurs Domestic interest groups especially in business would pressure their home governments to create regional institutions to perform particular tasks that would promote their economic interests International civil servants like the staff of the European Commission would as they fulfilled their assigned tasks 15 Haas was also influenced by the writings of Karl Deutsch According to Deutsch modernization leads to increasing levels of social interaction and communication among politically separated peoples which in turn leads to a convergence of individual and group values in the direction of more cosmopolitan norms This development re sults at least among democratic societies in the formation of a security community in which no state poses a threat to any other Karl W Deutsch Communications Theory and Political Integration in Philip E Jacob and James V Toscano eds The Integra tion of Political Communities Philadelphia Lippincott 1964 351 C H A P T E R T H I R T E E N develop a loyalty to the international institution rather than to their home governments As powerful domestic interests and individual states learned the utilitarian value of international organizations and as international civil servants transferred loyalty from their own states to international organizations the role of international institutions in managing regional and global affairs would grow Over time the re gional or global organization would be transformed from a means into an end itself Thus neofunctionalist theory like functionalist theory believed that economic cooperation would lead to political integration at either the regional or global level The idea that economic and technological forces are driving the world toward greater political integration is at the core of neofunction alism Forces leading to economic and political integration are embed ded in the modern economic system and tend to be selfreinforcing as each stage of economic integration encourages further integration Neofunctionalism assumes that economic and other welfare concerns have become or at least are becoming more important than such tradi tional concerns as national security and interstate rivalry Underlying this assumption is a belief that industrialization modernization democ racy and similar forces have transformed behavior The theory as sumes as well that the experience of integration leads to redefinition of the national interest and eventual transfer of loyalty from the nation state to emerging regional or global entities It is worth noting several ways in which neofunctionalism modified functionalism Whereas functionalism assumed that conscious political decisions would accelerate political integration neofunctionalist theory assumes that once the process of economic and technical integration has been launched unanticipated consequences spillovers from one functional area to another and the effects of learning will propel the process toward eventual political and economic unification One of neofunctionalisms core propositions is that the logic of functional spill overs would push political elites inevitably from economic cooperation toward political unification Neofunctionalism concentrates on the pro cess of regional integration itself and unlike economic theory does not attempt to evaluate explicitly the economic welfare consequences of regional integration Yet there is an unstated assumption that eco nomic and political integration are beneficial to members and nonmem bers alike Neofunctionalist ideas have strongly influenced the thinking of schol ars and public officials about European regional integration For exam ple Western Europeans in their concerted effort to create both a single market and a single European currency the euro have assumed that 352 P O L I T I C A L E C O N O M Y O F R E G I O N A L I S M economic and monetary unity would eventually force further steps to ward economic and political unification However especially following the French veto in 1967 of Britains effort to join the European Com munity it became obvious that the neofunctionalist logic of spillovers and feedbacks was not working And in 1975 Haas repudiated his own neofunctionalist theory 16 Few scholars have been equally honest and courageous in rejecting their own theories when faced with contrary evidence Neoinstitutionalism Domestic Politics and Intergovernmentalism Since scholars have recognized that functionalist and neofunctionalist thinking about regional integration has proved inadequate new ap proachesneoinstitutionalism domestic politics and intergovern mentalismhave influenced the writings of political scientists inter ested in economic and political integration 17 Neoinstitutionalism emphasizes the role of institutions in solving economic and other problems it maintains that institutions could help ameliorate market failures and solve collective action problems in economic and political integration The most prominent scholar in this school of thought is Robert Keohane who along with others has emphasized the need for international institutions to deal with market failures reduce transac tion costs and counter other problems Scholars argue that interna tional institutions or regimes assist states to solve collective action problems promote cooperation through facilitation of reciprocity titfortat strategies and link various issue areas In such ways re gional international institutions increase the incentives for states to solve their disputes and cooperate with one another Although this position has been very influential in the development of thinking about regional institutions it has not led to a specific theory of eco nomic and political integration Political scientists have also studied the effects on economic and political integration of such factors as the pressures of domestic eco nomic interests and the interests of political elites Their literature 16 Ernst Haas The Obsolescence of Regional Integration Theory Institute of Inter national Studies University of California Berkeley Research Series no 25 1975 17 Intergovernmentalism is discussed in Robert O Keohane and Stanley Hoffmann eds The New European Community Decision Making and Institutional Change Boulder Colo Westview Press 1991 Also Hans J Michelmann and Panayotis J Soldatos eds European Integration Theories and Approaches Lanham Md Univer sity Press of America 1994 A critique of intergovernmentalism is Geoffrey Garrett and George Tsebelis An Institutional Critique of Intergovernmentalism Interna tional Organization 50 no 2 spring 1996 26999 353 C H A P T E R T H I R T E E N emphasizing the importance for domestic groups of the distributive consequences of integration has noted that winners support integra tion and losers oppose it It has also recognized that political leaders will be guided by the consequences of integration for their own politi cal survival and that domestic interests and institutions may facilitate or discourage integration Many writings produced by political scien tists in this area are very similar to those of economists Although this literature supplements explanations that focus on the interna tional level by the year 2000 the literature had not been developed into a coherent theory or approach to economic and political integra tion The most significant approach by political scientists to economic and political integration since neofunctionalism is intergovernmental ism or more specifically liberal intergovernmentalism This ap proach derived from neofunctionalism neoinstitutionalism and other earlier theories of political integration shares with neofunction alism an emphasis on economic interests as the principal driving forces of regional integration Like neoinstitutionalism it stresses the importance of international that is regional institutions as a neces sary means of facilitating and securing the integration process How ever intergovernmentalism differs from earlier approaches in its con centration on the central role of national governments on the importance of powerful domestic economic interests and on bargain ing among national governments over distributive and institutional issues The most ambitious effort to develop a theory of economic and political integration based on intergovernmentalism is found in An drew Moravcsiks The Choice for Europe 1998 18 which concen trates on the pivotal responses of national governments to the increas ing interdependence of national economies and emphasizes the importance of international institutions in solving problems generated by increasing economic interdependence In Moravcsiks words My central claim is that the broad lines of European integration since 1955 reflect three factors patterns of commercial advantage the relative bargain ing power of important governments and the incentives to enhance the credi bility of interstate commitments Most fundamental of these was commercial interest European integration resulted from a series of rational choices made by national leaders who consistently pursued economic interestsprimarily the commercial interests of powerful economic producers and secondarily the 18 Andrew Moravcsik The Choice for Europe Social Purpose and State Power from Messina and Maastricht Ithaca Cornell University Press 1998 354 P O L I T I C A L E C O N O M Y O F R E G I O N A L I S M macroeconomic preferences of ruling governmental coalitionsthat evolved slowly in response to structural incentives in the global economy When such interests converged integration advanced 19 Thus private economic interests and shortterm macroeconomic pol icy preferences are considered responsible for European integration and as Moravcsik is proposing a general theory of regional integra tion for other integration efforts as well Moravcsiks belief that political motives such as FrenchGerman reconciliation and the integration of West Germany into a denational ized European political structure have played only a minor or sec ondary role in European political integration constitutes a serious weakness in his argument The statements of European leaders about the political imperative of economic and political integration make Moravcsiks disregard of the political motives quite astounding If Moravcsik is correct that regional integration efforts around the world are due to national responses to increasing international eco nomic interdependence then one would expect similar movements toward political integration elsewhere As he argues European inte gration differs only in that Europe has been touched more intensely by global economic developments 20 If one accepts Moravcsiks reasoning one would expect that North America would also be moving toward political integration After all the three North American economiesthe United States Canada and Mexicoare far more closely integrated in trade financial flows and foreign direct investment than are the economies of Western Eu rope Although intraEuropean trade has certainly increased greatly since World War II trade flows among the three North American economies especially between the United States and Canada are still considerably larger North American corporate linkages across na tional borders dwarf those among European firms and services fi nance and manufacturing in North America are more closely inte grated than are those in Western Europe Transnational European corporate integration in fact is just beginning and progress toward economic integration has led to corporate integration rather than vice versa European national financial markets also remain highly fragmented and separated from one another Yet despite the higher level of North American economic integration there is no pressure whatsoever for political unity Political integration is not occurring because the North American nations have no political motive to inte 19 Ibid 3 20 Ibid 5 355 C H A P T E R T H I R T E E N grate with one another as the nations of Western Europe have Surely the geopolitical concerns of the major West European powers should be given greater attention Realism Although a number of realists have written on political integration there is no generally accepted realist theory However the realist ap proach does emphasize the importance of power national political interests and interstate rivalries in the integrative process Realism regards regional integration especially political integration like that taking place in Western Europe as a political phenomenon pursued by states for national political and economic motives Realism which I have labeled statecentric realism assumes that a successful process of economic and political integration must be championed by one or more core political entities that are willing to use their power and influence to promote the integration process In West European inte gration regional leadership has been exercised by France and Ger many Perhaps there is no better example of the realist approach to politi cal integration than the following passage from Viners The Customs Union Issue on the unification of Germany in the midnineteenth cen tury It is generally agreed that Prussia engineered the customs union Zollverein primarily for political reasons in order to gain hegemony or at least influence over the lesser German states It was largely in order to make certain that the hegemony should be Prussian and not Austrian that Prussia continually op posed Austrian entry into the Union either openly or by pressing for a cus toms union tariff lower than highly protectionist Austria could stomach 21 The realist approach to economic regionalism also calls attention to several factors that limit peaceful economic and political integration Joseph Grieco for example stresses the importance of relative gains and of distributive issues in state calculations these inevitably make the type of longterm cooperation necessary to integration efforts very difficult to achieve 22 States for example are unlikely to willingly compromise their national security for economic gains in a regional arrangement thus far the European Union has experienced little 21 Jacob Viner The Customs Union Issue 9899 22 For a realist discussion of regional integration consult Joseph Grieco Systemic Sources of Variations in Regional Institutionalization in Western Europe East Asia and the Americas in Edward D Mansfield and Helen V Milner The Political Econ omy of Regionalism New York Columbia University Press 1997 356 P O L I T I C A L E C O N O M Y O F R E G I O N A L I S M progress in reaching agreement on common security or foreign poli cies In addition the economic concessions required to achieve re gional integration may be granted to allies but certainly not to poten tial adversaries Therefore economic and political integration may require a powerful leader that has an interest in and a capacity to promote a regional arrangement Ready examples are Germany in Western Europe EU the United States in North America NAFTA Japan in Pacific Asia and Brazil in South America Mercosur The historical experience in national development reveals that de spite neofunctionalist assertions economic unification has followed rather than preceded political unification Once a political decision has been made to achieve economic and monetary union neofunc tionalist logic and the solution of technical issues may propel deeper integration However at least to my knowledge there is no example of spillover from economic and monetary unification that has led au tomatically to political unification Indeed in some ways even the movement toward economic and political unification of Europe thus far has been historically unique Integration by peaceful means of such a large region has never before been attempted and there simply are no precedents to provide guidance regarding the future of Euro pean regionalization Whether or not Europe will ultimately succeed depends more on political than on economic developments Every regional arrangement represents cooperative efforts of indi vidual states to promote both national and collective objectives Some believe that economic regionalism and especially the effort to achieve European political unity signals a movement away from a statecen tric world and the beginning of a postnational international order To the contrary this effort and economic regionalism in general have been a response by nationstates to shared political and economic problems As the world economy has become more closely integrated regional groupings of states have increased their cooperation in order to strengthen their autonomy increase their bargaining position in disputes about distributive issues and promote other political or eco nomic objectives Regionalization is a means to extend national con cerns and ambitions rather than an alternative to a statecentered in ternational system Economic regionalism has spread because nationstates want the absolute benefits of a global economy at the same time that they seek to increase their own relative gains and protect themselves against external threats to their economic welfare and national security Con cerns over distributive issues and worries over national autonomy re flect the belief of national political and economic leaders that eco 357 C H A P T E R T H I R T E E N nomic competition must necessarily be a central concern in world politics Furthermore international economic competition necessi tates large domestic markets that enable domestic firms to achieve economies of scale In order to survive and prosper in an uncertain and rapidly changing world individual states and groups of states are adapting to the evolving economic technological and political environment as they have done many times in the past In the 1990s states have responded to intensely competitive and threatening global ization by forming or extending regional economic alliances or ar rangements under the leadership of one or more major economic powers Economic regionalism has become an important component in the national strategies of the major economic powers to strengthen their respective domestic economies and their international competitive ness They attempt to achieve at the regional level what they are no longer able to achieve at the national level 23 The Maastricht Treaty was intended to create a politically and economically unified Euro pean Union EU that would be the economic equal of Japan and the United States In North America ratification by Canada Mexico and the United States of the North American Free Trade Agreement NAFTA established a free trade area intended to create a strong North American and perhaps eventually a Western Hemisphere inte grated economy The third important regional movement in Pacific Asia has been led by a Japan determined to strengthen its regional and global position Although this Asian Pacific movement has been made manifest primarily through bilateral trade and investment link ages between Japan and other economies in the area an effort to increase political integration of the Asian Pacific region began with the founding of the Asian Pacific Economic Cooperation APEC community These three movements toward regional integration and the interrelationships among them will have a profound impact on the nature and structure of the world economy for some time to come An Eclectic Approach Efforts to develop a general theory of regional integration are unlikely to succeed The realist approach also has serious limitations There are too many different factors involved in regional movements around 23 Gibb and Michalak eds Continental Trading Blocs The Growth of Regionalism in the World Economy 1 358 P O L I T I C A L E C O N O M Y O F R E G I O N A L I S M the world the differences among various regional efforts are too great and too many assumptions that cannot be tested are necessarily involved in analysis of regional efforts My realist bias is to stress the political and strategic sources of regional efforts yet I acknowledge that this approach cannot fully account for every example of regional integration andor for the important differences among these efforts For example although political considerations have certainly been important in NAFTA and in Japans efforts to create an Asian Pacific economic bloc the principal motive in those cases has been fulfillment of private and national economic interests The dozens of efforts to create regional economies do possess one or more common elements an economic motive establishment of an external tariff of some kind andor a leader or leaders interested in promoting integration of the region Yet further generalization is difficult if not impossible Mo tives external tariffs and the role of leadership differ from one re gional arrangement to another and for this reason one must take an eclectic approach to understanding regional integration A universal theory or explanation of such a diverse and widerang ing phenomenon is undoubtedly impossible to formulate An eclectic approach is reasonable and should stress a number of factors First of all every regional effort involves some political motive sometimes one that is very ambitious as in European regional integration and sometimes quite modest as in North American regionalism Although the interests and pressures of powerful domestic groups may shape regional arrangements those arrangements are produced primarily by national interests as defined by the ruling elites of the states involved An eclectic approach should also incorporate recognition that re gionalism is stimulated when there is no strong international leader ship 24 As the United States became less willing to continue the leader ship role that it once performed groups of states framed their own solutions to international economic problems Weakening of the Bret ton Woods System of rulebased trade and monetary regimes encour aged the search for regional solutions Growing numbers of partici pants and the increasing complexity of the problems in international negotiations also encourage the movement toward regional arrange ments For example the large number of participants in GATTWTO trade negotiations has led groups of states to seek other solutions frequently easier to find at the regional than at the global level 24 Paul R Krugman The Move Toward Free Trade Zones in Policy Implications of Trade and Currency Zones A Symposium Sponsored by the Federal Bank of Kansas City Jackson Hole Wyoming 2224 August 1992 28 359 C H A P T E R T H I R T E E N Additional important factors in the spread of economic regionalism include the emergence of new economic powers intensification of in ternational economic competition and rapid technological develop ments The increased pace of economic change makes the choice be tween adjusting to new developments or resorting to protectionism even more vital In the 1970s nationstates usually responded to such challenges with New Protectionism that is the use of nontariff barri ers As that approach became less effective states in Western Europe North America and elsewhere formed customs unions and free trade areas to slow the adjustment process and protect themselves from the rapidly industrializing and highly competitive economies of Pacific Asia In the late 1990s protectionist efforts increased once again There are other factors that should be recognized in a new ap proach Economic regionalism is also driven by the dynamics of an economic security dilemma For example the movement toward Eu ropean unity became a factor in the US decision to support the North American Free Trade Agreement Japan fearing exclusion from both of those regional blocs stimulated Asian Pacific regional ism Other regional efforts around the world were also responses to earlier regional movements In effect nations have been trapped in a rather traditional Prisoners Dilemma of mutual distrust from which escape has become very difficult Finally additional factors influencing the movement toward eco nomic regionalism have included the increasing importance for world trade of oligopolistic competition the theory of strategic trade and economies of scale Earlier postwar economic thinking about region alism emphasized the trade creation and diversion consequences of regional trading arrangements but more recently the focus has been on the importance of internal and external economies of scale that could be achieved through economic integration 25 In principle of course the best route to promote economies of scale would be through free trade and completely open markets However many business and political leaders believe that protected regional arrange ments enable local firms to achieve such economies and thereby to increase their competitiveness visavis foreign firms Then when the firms are sufficiently strong they will be able to compete more suc cessfully against established oligopolistic firms in global markets 25 As noted earlier the term internal economies of scale refers to the decreased average costs enjoyed by a single large firm over a smaller firm The term external economies of scale refers to the fact that firms near one another can benefit from technological and other spillovers from neighboring firms Desmond Dinan ed Ency clopedia of the European Union Boulder Colo Lynne Rienner 1998 15358 360 P O L I T I C A L E C O N O M Y O F R E G I O N A L I S M Such reasoning and efforts to increase international competitiveness have certainly been factors underlying the movement toward regional integration Conclusion In Western Europe North America and Pacific Asia as well as else where dominant powers and their allies within a region have joined forces to solve regional problems and increase their bargaining lever age in global economic negotiations The countries of the European Union already participate in international trade negotiations as a re gional bloc Economic regionalism has also become a means to in crease the international competitiveness of regional firms Various forms of economic regionalism customs unions free trade areas and single markets provide to some extent such advantages of free trade as increased competition and economies of scale while simultaneously denying these advantages to outsiders unless they invest in the inter nal market and meet membercountry demands for local content technological transfers and job creation Regionalism also facilitates pooling of economic resources and formation of regional corporate alliances For all these reasons regionalism has become a central strategy used by groups of states to increase their economic and polit ical strength and therefore has become an extremely important fea ture of the global economy 361 CHAPTER FOURTEEN The NationState in the Global Economy T HE IDEA that the nationstate has been undermined by the trans national forces of economic globalization has appeared in writ ings on the international system and on the international economy Many writings have argued that international organizations IOs and nongovernmental actors are replacing nationstates as the dominant actors in the international system Books that have made this claim include those with such dramatic titles as The Retreat of the State The End of Geography and the End of Sovereignty 1 Daniel Yergin and Joseph Stanislaw maintain that the market has wrested control from the state over the commanding heights of the economy and that the economic role of the nationstate is just about at an end 2 Other writers believe a global economy has emerged or is emerging in which distinct national economies no longer exist and national economic policies are no longer possible 3 This chapter disagrees with such views and argues that the nationstate continues to be the major actor in both domestic and international affairs At the beginning of the twentyfirst century the nationstate is clearly under serious attack from both above and below and there is no doubt that there have been very important changes Within many nations the politics of identity and ethnic conflict is challenging the integrity of states as ethnic and regional groups seek independence or at least greater autonomy 4 Yet it is important to understand that the Kurds Palestinians and many other groups all want nationstates 1 Richard OBrien Global Financial Integration The End of Geography Walter B Wriston The Twilight of Sovereignty How the Information Revolution Is Transform ing Our World New York Scribners 1992 Joseph A Camilleri and Jim Falk End of Sovereignty The Politics of a Shrinking and Fragmenting World Brookfield Vt Elgar 1992 Susan Strange The Retreat of the State The Diffusion of Power in the World Economy New York Cambridge University Press 1996 2 Daniel Yergin and Joseph Stanislaw The Commanding Heights The Battle Be tween Government and the Marketplace That Is Remaking the Modern World New York Simon and Schuster 1998 3 Paul Hirst and Grahame Thompson Globalization in Question The International Economy and the Possibility of Governance London Polity Press 1996 1 4 Vincent CableThe Diminished NationState A Study in the Loss of Economic Power in What Future for the State Daedalus 124 no 2 spring 1995 4446 362 N A T I O N S T A T E A N D G L O B A L E C O N O M Y of their own they do not wish to eliminate nationstates but to divide present nationstates into units that they themselves can control It is also accurate to say that economic globalization and transnational economic forces are eroding economic sovereignty in important ways Nevertheless both the extent of globalization and the consequences of economic globalization for the nationstate have been considerably exaggerated For better or for worse this is still a statedominated world As Vincent Cable of the Royal Institute of International Affairs London has noted it is not easy to assess globalizations implica tions for the nationstate 5 Although the economic role of the state has declined in certain significant ways it has expanded in others and therefore it is inaccurate to conclude that the nationstate has become redundant or anachronistic As Cable says the situation is much messier than that The impact of the global economy on indi vidual nations is highly uneven and its impact varies from issue to issue finance is much more globalized than are services and industrial production While globalization has reduced some policy options the degree of reduction is highly dependent on national size and eco nomic power the United States and Western Europe for example are much less vulnerable to destabilizing financial flows than are small economies Indeed the importance of the state has even actually in creased in some areas certainly with respect to promoting interna tional competitiveness through support for R D for technology policy and for other assistance to domestic firms Economic globalization is much more limited than many realize and consequently its overall impact on the economic role of the state is similarly limited Moreover although economic globalization has been a factor in whatever diminishment of the state may have oc curred ideological technological and international political changes have had an even more powerful influence Furthermore many and perhaps most of the social economic and other problems ascribed to globalization are actually due to technological and other develop ments that have little or nothing to do with globalization Even though its role may have diminished somewhat the nationstate re mains preeminent in both domestic and international economic af fairs To borrow a phrase from the American humorist Mark Twain I would like to report that the rumors of the death of the state have been greatly exaggerated 6 5 Ibid 38 6 Mark Twain was a nineteenthcentury American author whose obituary was mis takenly published before his death leading Twain to comment that rumors of his death were greatly exaggerated 363 C H A P T E R F O U R T E E N The Limited Nature of Economic Globalization In one sense globalization has been taking place for centuries when ever improvements in transportation and communications have brought formerly separated peoples into contact with one another The domestication of the horse and camel the invention of the sailing ship and the development of the telegraph all proved powerful instru ments for uniting people although not always to their liking For thousands of years ideas artistic styles and other artifacts have dif fused from one society to another and have given rise to fears similar to those associated with economic globalization today Nevertheless it is important to discuss the economic globalization that has resulted from the rapid economic and technological integration of national societies that took place in the final decades of the twentieth century especially after the end of the Cold War This recent global economic integration has been the result of major changes in trade flows of the activities of multinational corporations and of developments in international finance Despite the increasing significance of economic globalization the integration of the world economy has been highly uneven restricted to particular economic sectors and not nearly as extensive as many believe As a number of commentators have pointed out there are many ways in which the world is less integrated today than it was in the late nineteenth century This should remind us that although the technology leading to increased globalization may be irreversible na tional policies that have been responsible for the process of economic globalization have been reversed in the past and could be reversed again in the future As the twentyfirst century opens the world is not as well inte grated as it was in a number of respects prior to World War I Under the gold standard and the influential doctrine of laissezfaire for ex ample the decades prior to World War I were an era when markets were truly supreme and governments had little power over economic affairs Trade investment and financial flows were actually greater in the late 1800s at least relative to the size of national economies and the international economy than they are today Twentiethcen tury changes appear primarily in the form of the greatly increased speed and absolute magnitude of economic flows across national bor ders and in the inclusion of more and more countries in the global economy Yet economic globalization is largely confined to North America Western Europe and Pacific Asia And even though these industrial economies have become much more open imports and in 364 N A T I O N S T A T E A N D G L O B A L E C O N O M Y vestments from abroad are still small compared to the size of the domestic economies For example American imports rose from 5 per cent of the total US production in 1970 to just 13 percent in 1995 even though the United States was the most globalized economy Although trade has grown enormously during the past half century trade still accounts for a relatively small portion of most economies moreover even though the number of tradables has been increas ing trade is still confined to a limited number of economic sectors The principal competitors for most firms with important exceptions in such areas as motor vehicles and electronics are other national firms The largest portions of foreign direct investment flows are in vested in the United States Western Europe and China a very small portion of the investment in sectors other than raw materials and resources has been invested in most less developed countries Interna tional finance alone can be accurately described as a global phenome non Yet even the globalization of finance must be qualified as much of international finance is confined to shortterm and speculative in vestment The most important measure of the economic integration and inter dependence of distinct economies is what economists call the law of one price If identical goods and services in different economies have the same or nearly equal prices then economists consider these econ omies to be closely integrated with one another However evidence indicates that the prices of identical goods around the world differ considerably whether measured by The Economist magazines Big Mac index or by more formal economic measures 7 When the law of one price is applied to the United States it is clear that American prices differ greatly from those of other countries especially Japans Price differentials in the cost of labor around the world are particu larly notable and there are large disparities in wages All of this clearly suggests that the world is not as integrated as many proclaim The significant and sizable decline in migration is one of the major differences between latenineteenthcentury globalization and global ization of the early twentyfirst century During the past half century the United States has been the only country to welcome large numbers of new citizens Although Western Europe has accepted a flood of refugees and guest workers the situation in those countries has been and remains tenuous few have been or will be offered citizen 7 Charles Engel and John H Rogers Regional Patterns in the Law of One Price The Roles of Geography versus Currencies in Jeffrey A Frankel ed The Regional ization of the World Economy Chicago University of Chicago Press 1998 153 365 C H A P T E R F O U R T E E N ship The globalization of labor was considerably more advanced prior to World War I than afterward In the late nineteenth century millions of Europeans crossed the Atlantic to settle as permanent resi dents in North America West Europeans also migrated in significant numbers to such lands of recent settlement as Australia Argentina and other temperatezone regions There were large migrations of In dians and Chinese to Southeast Asia Africa and other tropical re gions All these streams of migration became powerful determinants of the structure of the world economy 8 In the early twentyfirst cen tury labor migration is no longer a major feature of the world econ omy and even within the European Union migration from one mem ber nation to another is relatively low Barriers to labor migration are built by policies intended to protect the real wages and social welfare of the nations citizens and the modern welfare state is based on the assumption that its benefits will be available only to its own citizens 9 Some reformers in industrialized countries have constructed an ethical case that national wealth should be shared with the destitute around the world but to my knowledge even they have not advocated elimination of the barriers to interna tional migration in order to enable the poor to move to more wealthy countries and thus decrease international income disparities I find it remarkable that in the debate over globalization little attention has been given to the most important factor of production namely labor and labor migration For the billions of people in poor countries national borders certainly remain an important feature of the global economy Alleged Consequences of Economic Globalization The conjuncture of globalization with a number of other political economic and technological developments transforming the world makes it very difficult to understand economic globalization and its consequences Among farreaching economic changes at the end of the twentieth century have been a shift in industrialized countries from manufacturing to services and several revolutionary technologi cal developments associated with the computer including emergence of the Internet and information economy The skills and education 8 W Arthur Lewis The Evolution of the International Economic Order Princeton Princeton University Press 1978 9 James Mayall Nationalism and International Society Cambridge Cambridge Uni versity Press 1990 Chapter 5 366 N A T I O N S T A T E A N D G L O B A L E C O N O M Y required by jobs in the computer age place unskilled labor in the industrialized countries at a severe disadvantage in their wages and job security Although some economic and technological developments associ ated with the computer including the rapid advances in telecommuni cations have certainly contributed to the process of globalization and globalization in some cases has accentuated these economic and technological changes the two developments are not synonymous In fact the contemporary technological revolution has been a far more pervasive and in many ways a much more profound develop ment than is globalization at least thus far For example the most important development currently altering individual lives is the in credible revolution in the biological sciences such as biological engi neering Yet this important development in human affairs has nothing whatsoever to do with globalization as it is commonly conceived Many of the problems alleged to be the result of economic global ization are really the consequence of unfortunate national policies and government decisions Environmentalists rage against globaliza tion and its evils yet most environmental damage is the result of the policies and behaviors of national governments Air water and soil pollution result primarily from the lax policies of individual nations andor from their poor enforcement procedures The destruction of the Amazon forest has been caused principally by the Brazilian gov ernments national development policies in the United States forest clearcutting is actually promoted by generous government subsidies to logging companies Landhungry peasants in Southeast Asia are permitted to destroy forests to acquire cultivable land Small farmers in France the United States and elsewhere blame globalization for their economic plight but small farms are victims of economictech nological changes that have increased the importance of economies of scale in agriculture Unfortunately large farms and agribusinesses are now best suited to take full advantage of such economictechno logical changes The American agricultural sector especially the large farms even benefit from generous government subsidies It would be easy to expand the list of problems generally attributed to globaliza tion that have really been caused by technological changes by na tional government policies or by other wholly domestic factors In Western Europe globalization is frequently blamed for many of the problems that have emerged from the economic and political integration of the region Both globalization and regionalism are characterized by lowered economic barriers restructuring of business and other economicsocial changes it is easy therefore to see why 367 C H A P T E R F O U R T E E N some have conflated the two developments into one Yet globaliza tion and regionalism are different especially in the goals that each is seeking to achieve The tendency to blame globalization for many vexing problems of modern life is due in part to nationalistic and xenophobic attitudes on the political right and an anticapitalist mentality on the political left Nationalistic attitudes have been expressed by Ross Perot Pat rick Buchanan and American organized labor the latter long ago gave up the slogan workers of the world unite in favor of their own parochial interests The leftist criticism of capitalism runs deep in some peoples and countries and within advanced capitalist econo mies most notably France The antagonism toward capitalism is di rected at the principal representatives of the capitalist system in the modern world the United States large multinational firms and such international economic institutions as the International Monetary Fund and World Trade Organization When I note these criticisms I myself do not intend to endorse such excesses of capitalism as ram pant commercialism enormous disparities in wealth and privilege advertisings creation of wants or the worship of wealth as the measure of all things Capitalism is a system based on selfinterest that is too frequently made manifest in outright greed Despite capi talisms serious flaws the evils of todays world will not be solved by attacks on globalization One may say about capitalism what Win ston Churchill is reputed to have said about democracy that it is the worst of all social systems except for all the others Elsewhere in this book and in another of my books The Challenge of Global Capitalism I have addressed many of the negative conse quences alleged to have been caused by globalization and have argued that most of the charges against globalization are wrong misleading or exaggerated 10 Domestic and international income disparities the problems of unskilled workers and the alleged race to the bottom in modern welfare states in general should not be attributed to eco nomic globalization In almost all cases such other factors as techno logical changes national policies or the triumph of conservative eco nomic ideologies carry primary responsibility for these developments Those particularly concerned about income inequalities among na tional societies should recognize that globalization in the form of ex ports from industrializing to industrialized countries has actually 10 A very effective critique of the antiglobalist position is found in Geoffrey Garrett Global Markets and National Politics International Organization 52 no 4 autumn 1998 787824 368 N A T I O N S T A T E A N D G L O B A L E C O N O M Y greatly benefited the industrializing countries furthermore very few countries have developed in this century without active participation in the global economy Effectiveness of Macroeconomic Policy Since the end of World War II and especially since governments ac cepted Keynesian economics in the early postwar era national gov ernments in the advanced industrialized economies have been held responsible for national economic performance States were assigned the tasks of promoting national economic stability and steering their economies between the undesirable conditions of recession and infla tion Through macroeconomic policies the state has been able to con trol at least to some extent the troubling vicissitudes of the market However the argument that the power of the state over economic affairs has significantly declined implies that national governments can no longer manage their economies While it is true that macroeco nomic policy has become more complicated in the highly integrated world economy of the twentyfirst century these policies do still work and can achieve their goals at least as well as in the past What better example than the Federal Reserves very successful management of the American economy in the midtolate 1990s Moreover today as in the past the principal constraints on macroeconomic policy are to be found at the domestic rather than at the international level Macroeconomic policy consists of two basic tools for managing a national economy fiscal policies and monetary policies The principal instruments of fiscal policy are taxation and government expendi tures Through lowering or raising taxes andor increasing or decreas ing national expenditures the federal government Congress and the Executive can affect the national level of economic activities Whereas a federal budget deficit spending more than tax receipts will stimulate the economy a budget surplus spending less than tax receipts will decrease economic activities Monetary policy works through its determination of the size and velocity of a nations money supply The Federal Reserve can stimulate or depress the level of eco nomic activities by increasing or restricting the supply of dollars avail able to consumers and producers The principal method employed by the Federal Reserve to achieve this goal is to determine the national level of interest rates whereas a low interest rate stimulates economic growth a high rate depresses it Many commentators argue that the effectiveness of monetary pol icy has been significantly reduced by increased international financial 369 C H A P T E R F O U R T E E N flows If for example a central bank lowers interest rates to stimulate the economy investors will transfer their capital to other economies with higher interest rates and thus counter the intended stimulus of lower rates Similarly if a central bank increases interest rates in or der to slow the economy investment capital will flow into the econ omy counter the intended deflationary effects of higher rates and stimulate economic activities In all these ways economic globaliza tion is believed to have undermined the efficacy of fiscal and mone tary policy Therefore some consider national governments no longer able to manage their economies To examine this contention it is helpful to apply the logic of the trilemma or irreconcilable trinity discussed in Chapter 9 Every nation is confronted by an inevitable tradeoff among the following three desirable goals of economic policy fixed exchange rates na tional autonomy in macroeconomic policy and international capital mobility A nation might want a stable exchange rate in order to reduce economic uncertainty and stabilize the economy Or it might desire discretionary monetary policy to avoid high unemployment and steer the economy between recession and inflation Or a govern ment might want freedom of capital movements to facilitate the con duct of trade foreign investment and other international business activities Unfortunately a government cannot achieve all three of these goals simultaneously It can obtain at most two For example choosing a fixed and stable exchange rate along with some latitude for independent monetary policies would mean forgoing freedom of capital movements because international capital flows could under mine both exchange rate stability and independent monetary policies On the other hand a country might choose to pursue macroeconomic policies to promote full employment but it then would have to sacri fice either a fixed exchange rate or freedom of capital movement Such an analysis tells us that although economic globalization does constrain government policy options it does not impose a financial straitjacket on national macroeconomic policies Whether an individ ual nation does or does not have the capacity for an independent macroeconomic policy is itself a policy choice If a nation wants the capability to pursue an independent macroeconomic policy it can achieve that goal by abandoning either fixed exchange rates or capital mobility Different countries do in fact make different choices The United States for example prefers independent monetary policy and freedom of capital movements and therefore sacrifices exchange rate stability members of the European Economic Monetary Union EMU on the other hand prefer fixed exchange rates and have cre 370 N A T I O N S T A T E A N D G L O B A L E C O N O M Y ated a common currency to achieve this goal Some other countries that place a high value on macroeconomic independenceChina for examplehave imposed controls on capital movements Different domestic economic interests also have differing prefer ences Whereas export businesses have a strong interest in the ex change rate domesticoriented businesses place a higher priority on national policy autonomy Investors prefer freedom of capital move ment whereas labor tends to be opposed to such movement unless the movement should mean increased investment in their own nation Economic globalization in itself does not prevent a nation from using macroeconomic policies for managing its economy The mechanisms employed to conduct monetary policy have not been seriously affected by globalization Although various central banks operate differently from one another an examination of the ways in which the American Federal Reserve the Fed steers the Ameri can economy is instructive and reveals that at least in the American case globalization has had only minimal effects Through its power to increase or decrease the number of dollars available to consumers and producers liquidity the Fed is able to steer the overall economy The level of national economic activity is strongly influenced by the size of the nations money supply an in crease in the money supply stimulates economic activities and a de crease slows down economic activity The Fed has three basic instru ments to influence the nations supply of money The first directly affects the money supply the other tools work indirectly through the banking system The Feds primary means for management of the economy is open market operations conducted through the Open Market Desk of the Federal Reserve Bank of New York Through sale or purchase of US government bonds directly to the public the Fed can influence the overall level of national economic activity If for example the Fed wants to slow the economy it sells US Government bonds This takes money or liquidity out of the economy If on the other hand the Fed wants to stimulate the economy it uses dollars to purchase US Government bonds and thus increases the money or liquidity in the economy The Fed can also change the discount rate which is the interest rate on loans that the Fed makes directly to the nations commercial banks The Fed for example loans money to banks whose reserves fall below the Feds reserve requirements see below this may hap pen if a bank has made too many loans or is experiencing too many withdrawals By lending to private banks and increasing the reserves 371 C H A P T E R F O U R T E E N of those banks the Fed enables banks to make more loans and thus to increase the nations money supply Whereas raising the discount rate decreases loans and money creation lowering of the discount rate increases loans and money creation These changes in turn have a powerful influence on the overall level of economic activity Another tool that the Fed has available is its authority to determine the reserve requirements of the nations banks Reserve requirements specify the minimal size of the monetary reserves that a bank must hold against deposits subject to withdrawal Reserve requirements thus determine the amount of money that a bank is permitted to lend and thereby how much money the bank can place in circulation Through raising or lowering reserve requirements the Fed sets a limit on how much money the nations banks can inject into the economy However this method of changing the money supply is used infre quently because changed reserve requirements can be very disruptive to the banking system Globalization and a more open world economy have had only min imal impact on the Feds ability to manage the economy Yet the effectiveness of open market operations has probably been somewhat reduced by growth of the international financial market and the pur chase or sale of US securities by foreigners certainly affects the na tional money supply In the late 1990s it was estimated that approxi mately 150 billion was held overseas However the effect of that large amount is minimized by the size of the more than 8 trillion domestic economy Also the American financial system like that of other industrialized countries exhibits a home bias that is to say most individuals keep their financial assets in their own currency It is possible however that central banks in smaller and weaker econo mies find that their ability to manage their own money supply has been decreased as was exemplified by the 1997 Asian financial crisis One should note that the continuing power of the Fed over the banks and the money supply through control of the interest rate has been challenged by the development of the credit card and other new forms of money These credit instruments have decreased at least somewhat the effectiveness of the Feds use of this instrument to con trol the economy Still more problematic for the Fed is the increasing use of emoney in Internet commerce In effect these developments mean that the monopoly of money creation once held by the Fed and the banking system is being diluted Through use of a credit card and or participation in ecommerce an individual or business can create money Yet at some point emoney and other novel forms of money must be converted into real or legal tender and at that point the 372 N A T I O N S T A T E A N D G L O B A L E C O N O M Y Fed retains control of the creation of real money Thus although the monetary system has become much more complex the Fed still has ultimate control over that system and through it the overall economy Although the power of central banks over interest rates and the money supply has been somewhat diminished as long as cash and bank reserves remain the ultimate means of exchange and of settle ment of accounts central banks can still retain control over the money supply and hence of the economy In fact even if everyone switched to electronic means of payment but credit issuers still settled their balances with merchants through the banking system as hap pens with credit cards now central banks would still retain overall control However one day emoney could displace other forms of money If and when this develops financial settlements could be car ried out without going through commercial banks and central banks would lose their ability to control the economy through interest rates Such a development could lead to the denationalization of money However it seems reasonable to believe that some public authority would still be needed to control inflation and monitor the integrity of the computer system used for payments settlements With respect to reserve requirements intense competition among international banks has induced some central banks to reduce reserve requirements in order to make the domestic banking industry more competitive internationally Japanese banks for example have long been permitted by the government to keep much smaller reserves than American banks One of the major purposes of the Basle Agreement 1988 was to make reserve requirements more uniform throughout the world Rumor has it that this agreement was engineered by the Fed to decrease the international competitiveness of Japanese and other foreign banks visavis American international banks Whatever the underlying motive the agreement has been described as a re sponse to financial globalization and the establishment of uniform international reserve requirements has largely reestablished their ef fectiveness as instruments of policy The most important constraints on macroeconomic policy are found at the domestic level If an economy were isolated from the international economy fiscal policy would be constrained by the cost of borrowing If a national government were to use deficit spending to stimulate its economy the resulting budget deficit would have to be financed by domestic lenders In that situation an upper limit would be placed on government borrowing because as the budget deficit and the costs of servicing that deficit rose bond purchasers 373 C H A P T E R F O U R T E E N would become more and more fearful that the government might de fault on its debt andor use monetary policy to inflate the money supply and thus reduce the real value of the debt Increased risk as debt rises causes lenders to stop lending andor to charge higher and higher inter est rates this then discourages further borrowing by the government Also another important constraint on monetary policy in a domestic economy is the threat of inflation this threat places an upper limit on the ability of a central bank to stimulate the economy by increasing the money supply andor lowering the interest rate At some point the threat of inflation will discourage economic activity In short there are limits on macroeconomic policy that have nothing whatsoever to do with the international economyand these domestic constraints ex isted long before anyone had heard the term globalization Economic globalization has made the task of managing an econ omy easier in some ways and more difficult in others On the one hand globalization has enabled governments to borrow more freely the United States in the 1980s and 1990s borrowed heavily from Jap anese and other foreign investors in order to finance a federal budget deficit and a high rate of economic growth However this debtfi nanced growth strategy as Susan Strange pointed out first in Casino Capitalism 1986 and again in Mad Money 1998 is extraordinarily risky and can not continue forever Fearing collapse of the dollar investors could one day flee dollardenominated assets for safer assets denominated in other currencies 11 The consequences of such flight could be devastating for the United States and for the rest of the world economy Thus although economic globalization has increased the latitude of governments to pursue expansionary economic policies through borrowing excessively abroad such serious financial crises of the postwar era as the Mexican crisis in 19941995 the 1997 East Asian financial crisis and the disturbing collapse of the Russian ruble in August 1998 demonstrate the huge and widespread risks associated with such a practice Economic globalization and the greater openness of domestic econ omies have also modified the rules of economic policy Certainly the increasing openness of national economies has made the exercise of macroeconomic policy more complex and difficult This does not mean that a national government can no longer guide the economy around the dangerous shoals of inflation and recession but it does mean that the risk of shipwreck has grown 11 Susan Strange Casino Capitalism Oxford Blackwell1986 and Mad Money From the Author of Casino Capitalism Manchester UK Manchester University Press 1998 374 N A T I O N S T A T E A N D G L O B A L E C O N O M Y The Need for a Historical Perspective The globalization thesis lacks a historical perspective Those individu als who argue that globalization has severely limited economic sover eignty appear to believe that governments once possessed unlimited national autonomy and freedom in economic matters Their argument assumes that nationstates have enjoyed unrestricted ability to deter mine economic policy and manage their economies and that govern ments were free because they were not subordinate to or encumbered by transnational market forces As proponents of the globalization thesis contrast economic policy in the twentyfirst century to this imagined past they conclude that nationstates for the first time ever have become constrained by the increased integration of national economies through trade financial flows and the activities of multi national firms In effect having assumed that states once had com plete economic freedom these individuals misperceive the reality of the fundamental relationship between the state and the economy When viewed from a more accurate historical perspective the rela tionship of state and market in the contemporary era is neither partic ularly startling nor revolutionary In the decades prior to World War I national governments had little effective control over their economies Under the classical gold standard of fixed exchange rates governments were more tightly bound by what Barry Eichengreen has called golden fetters than they are in the earlytwentyfirst century world of flexible rates Moreover as Nobel Laureate Arthur Lewis has noted prior to World War I the economic agenda of governments everywhere was limited to the efforts of central banks to maintain the value of their currenc ies 12 As Keynes pointed out in The Economic Consequences of the Peace 1919 national economic policy did not concern itself with the welfare of the lower orders of society 13 This minor and highly constrained role of the state in the economy changed dramatically with World War I and subsequent economic and political develop ments Throughout the twentieth century the relationship of state and market indeed changed significantly as governments harnessed their economies for total war and to meet their citizens rising economic 12 Barry Eichengreen Golden Fetters The Gold Standard and the Great Depression New York Oxford University Press 1992 and W Arthur Lewis Growth and Fluctu ations 18701913 London Allen and Unwin 1978 13 John Maynard Keynes The Economic Consequences of the Peace London Mac millan 1919 375 C H A P T E R F O U R T E E N expectations The world wars of the twentieth century the Great De pression of the 1930s and the immense economic demands of the Cold War elevated the states role in the economy During periods of intense concern about security national governments used new tools to manage their economies and began to exercise unprecedented con trol over their economies The Great Depression the rise of organized labor and the sacrifices imposed on societies by World War II led Western governments to expand their activities to guarantee the wel fare of their citizens For some years the perceived success of the communist experiment also encouraged governments to help Keyness lower orders and after World War II governments in every ad vanced economy assumed responsibility for promotion of full em ployment and provision of a generous and high level of economic welfare Conclusion The argument that the nationstate is in retreat is most applicable to the United States Western Europe and perhaps Japan The end of the Cold War represented the end of a century and a half of rapid economic development and politicalmilitary conflict Since the Amer ican Civil War 18611865 the FrancoPrussian War 18701871 and the RussoJapanese War 19041905 the forces of nationalism industrialization and statecreation had driven the industrialized powers of Europe the United States and Japan World War I World War II and the Cold War forged the modern nationstate as an eco nomic and warmaking machine During these decades of interstate rivalry the economy was often harnessed to the needs of the national war machine This bellicose epoch appears to have ended and the industrialized countries may be retreating to their more modest late nineteenthcentury status Yet one must ask whether the forces of nationalism industrialization and statecreation might not be caus ing a repeat of the tragic Western experience in the developing econo mies of Asia Africa and elsewhere Thus far there is little evidence to suggest that these countries will avoid repeating the mistakes made by the industrialized world 376 CHAPTER FIFTEEN Governing the Global Economy I N HIS PIONEERING Economics of Interdependence 1968 Richard Cooper argued that the most serious problem of the postwar inter national economy was the intensifying clash between the economic and technological forces unifying the globe and the worlds continu ing political fragmentation 1 Trade investment and financial flows Cooper pointed out were creating an increasingly integrated and highly interdependent global economy Yet nationstates through such means as trade protection subsidies and industrial policies were resisting these integrating forces and in doing so were undermining the world economy Tension between the evolving global economy and political fragmentation Cooper argued was causing economic instability and threatening to undermine the openness and efficiency of the world economy Cooper went on to evaluate various solutions that had been pro posed to the clash between the irresistible force of economics and the immovable object of politics He concluded that the ideal solu tion was some type of international governance of the global econ omy 2 However he doubted that nations would be willing to sacrifice national sovereignty and politicaleconomic autonomy for the sake of a wellfunctioning international economy Since Coopers 1968 advocacy of improved international gover nance of the world economy a number of significant developments have increased the relevance of his diagnosis but made his solution even more difficult to attain When Cooper published his book the relevant world economy reflected in the books subtitle Economic Policy in the Atlantic Community was composed primarily of West ern Europe North America and a weak periphery Since that time industry and economic power have diffused from the North Atlantic to Japan the industrializing countries of Pacific Asia and other in dustrializing powers in Latin America and elsewhere In 1968 despite 1 Richard N Cooper The Economics of Interdependence Economic Policy in the Atlantic Community New York McGrawHill 1968 Although Coopers book is obviously dated its analytical and theoretical framework continues to be important for anyone interested in international political economy 2 Ibid 262 377 C H A P T E R F I F T E E N important differences between the continental European tradition of stakeholdercorporatist capitalism and AngloSaxon shareholderfree market capitalism the North Atlantic economies have shared a mar ketoriented concept of capitalism with modest state intervention To day Japan and most industrializing economies have very different cultural traditions and national systems of political economy these differences include extensive state interventionism and close govern mentbusiness ties In 1968 the level of economic interdependence among national economies was still rather modest Now more than thirty years later the forces of economic globalization have created a more integrated global economy Coopers analysis strongly emphasized the necessary political foun dations of international economic cooperation Cooper argued that international cooperation in economic matters was unlikely unless there was political support from the major economic powers At that time he believed that the political foundation for improved coopera tive management of the international economy could be found within the Atlantic Community He suggested however that if the Ameri canWest European political alliance should prove unable to provide the political glue for economic policy cooperation then it would be preferable to break up the North Atlantic countries into smaller units that could cooperate closely and more easily 3 Coopers words have proved prescient Economic regionalism has made governance of the global economy both more necessary and more difficult to attain To day the North Atlantic region is divided into the European Union and the North American Free Trade Agreement areas and their fu ture relationships cannot be predicted Throughout the global econ omy other regional blocs have been emerging Three decades after publication of Coopers book setting forth the great need for international governance the rapid globalization of the world economy has elevated the governance issue to the top of the international economic agenda 4 Neither domestic economies nor the increasingly integrated world economy can rely on markets alone to police themselves An international governance mechanism is needed to assume several functions in the new global economy in particular it must provide certain public goods and resolve market failures Pro 3 Ibid 7778 4 A useful and wideranging exploration of the governance issue is James N Rosenau and ErnstOtto Czempiel eds Governance without Government Order and Change in World Politics New York Cambridge University Press 1992 Another valuable writing on the subject is Raimo V Vayrynen ed Globalization and Global Gover nance London Rowman and Littlefield 1999 378 G O V E R N I N G T H E G L O B A L E C O N O M Y vision of international public goods must include maintaining the rule of law and especially provide for the settlement of disputes in trade FDI and other areas ensuring monetary and financial stability setting common standards and regulations for business managing global communication and transportation and solving environmental problems Although many neoclassical economists and some liberal thinkers believe that only minimal rules are necessary many scholars of inter national political economy argue that extensive rules or formal re gimes are needed There are three predominant positions regarding governance neoliberal institutionalism new medievalism and trans governmentalism 5 Neoliberal institutionalism based on the contin ued importance of the state believes that formal international regimes and institutions are necessary Whereas staterealism emphasizes the everpresent problem of interstate conflict and rivalry neoliberal in stitutionalism stresses interstate cooperation The new medievalism is based on the assumption that the state and the statesystem have been undermined by economic technological and other developments and are being eclipsed by nongovernmental actors and the emergence of an international civil society New medievalists believe that the end of national sovereignty and the resulting diffusion of power will en able selfless nongovernmental organizations NGOs to solve the worlds pressing environmental and other problems Transgovern mentalism argues that international cooperation by domestic govern ment agencies in specific functional areas is rapidly replacing the deci sionmaking functions of centralized national governments in the management of the global economy Neoliberal Institutionalism Like realism neoliberal institutionalism accepts the continued exis tence and importance of the nationstate in international affairs how ever it generally assumes that the state is a liberal marketoriented state in the American sense more interested in cooperation and abso lute gains than in conflicts over relative gains Neoliberal institution alists believe that international institutions have become sufficiently strong to meet the challenges of a globalized international economy Moreover if existing regimes are found deficient new ones can be created or easily modified as they have been in the past An impor 5 These useful categories are based on AnneMarie Slaughter The Real New World Order Foreign Affairs 76 no 5 SeptemberOctober 1997 18397 379 C H A P T E R F I F T E E N tant example of a substantial reform of an international institution is found in the 1995 replacement of the General Agreement on Tariffs and Trade GATT by the World Trade Organization WTO the latter has greater authority over trade matters more resources and more power to enforce its decisions The World Bank and the Interna tional Monetary Fund are being reformed as the twentyfirst century opens New international conventions on environmental and other important matters have been implemented The types of international regimes and institutions advocated by neoliberal institutionalism have achieved considerable success De spite some failings the IMF WB and GATTWTO have improved significantly the ways in which the international economy functions However this approach to international governance has a number of limitations As the world has become more integrated and complex new issues have arisen a number of existing regimes have proven to be quite inadequate to fulfill the tasks assigned to them For example the regimes governing the areas of finance and money have proved seriously deficient The increased integration and instability of finan cial markets and exchange rate fluctuations pose a serious threat to the stability of the global economy Efforts to create an international regime for multinational corporations such as the Multilateral Invest ment Agreement have reached stalemate because of strong opposi tion from many countries and powerful interest groups There is no regime for economic development one of the most pressing issues in the world Although Article XXIV of the GATTWTO was intended to regulate formation of regional economic arrangements it is almost totally ineffective In short the task of reforming existing regimes and creating new ones is exceptionally difficult There are formidable obstacles to achievement of the neoliberal institutionalist ideal of a regimebased international economy and the issue of compliance is particularly challenging This problem con tinues to limit the effectiveness of international organizations the many books and articles on compliance have not helped very much There are few generally accepted principles and policy prescriptions upon which regimes can be constructed The Bretton Woods regimes dealing with trade and monetary affairs were based on such Western legal and economic ideas as the transparency of commercial dealings and limited state intervention in the economy and the triumph of neoliberalism in the 1980s reinforced such liberal principles How ever as economic integration spread among many and more diverse economies and also deepened fundamental differences among na tional systems of political economy regarding economic principles 380 G O V E R N I N G T H E G L O B A L E C O N O M Y and legitimate policy have challenged Western ideals American and Japanese notions of what is fair in international economic competi tion are particularly divergent Increasing regionalization of the global economy has proved to be a popular way of dealing with the problems created by such national differences The clash between different national systems of political economy has intensified but most American economists and public officials expect that the process of convergence will eventually lead to world wide acceptance of the policy prescriptions of neoclassical economics and a free market following the American model Some aspects of the Asian model were certainly discredited by the 1997 financial crisis and some states have retreated from prior aggressive government in tervention in the economy Yet in many countries there is strong resistance to permitting the whims of the market to determine a soci etys welfare andor the nations position in the global system Many national leaders bitterly resent the constraints that the emphasis on the market imposes on economic policy notable examples of such resentment have appeared in Malaysia and South Korea In defiance of free market ideology Malaysia in the 1990s imposed capital con trols and South Korea strongly resisted American demands to liqui date the chaebol There have also been serious revolts against trade liberalization in the West including the US congressional defeat in 1997 of fast track legislation Furthermore the American and Brit ish model of shareholder capitalism AngloSaxon capitalism is re jected by Japan continental Europe and many other nations Al though important changes are taking place in these countries they still consider a corporation to be a community with social responsibil ities and resist thinking of corporations as bundles of contracts and commodities to be bought and sold It is noteworthy that in Japan East Asia and other countries corporations are important providers of social insurance and other forms of social welfare As this role becomes threatened by global competition resentment against the AngloSaxon model is likely to increase At the opening of the twentyfirst century international institutions are faced with a number of immediate issues whose outcome will determine their future A pressing issue given public prominence in 1999 by the Seattle protestors against the World Trade Organization is what scholars call the democratic deficit international economic institutions are criticized because they are not accountable to any democratic electorate Closely tied to this issue is the gap between the authority of existing institutions and the changing distribution of power in the international system Despite the significant shift in eco 381 C H A P T E R F I F T E E N nomic power that occurred in the last half of the twentieth century decisionmaking authority and responsibility in the IMF WTO and World Bank continue to be disproportionately accorded to the United States and to a lesser extent Western Europe Still another issue is the question of institutional reform this is especially relevant for the IMF because of intense criticism of the organization by both the polit ical left and right in the United States Democratic Deficit In the interest of efficient decisionmaking and in deference to mem ber governments desires to keep their national affairs confidential every important international organizationincluding the WTO IMF and World Bankoperates largely in secrecy The predilection toward secrecy is reinforced by the fear that negotiations on trade monetary and other important economic matters could roil and seri ously destabilize global markets a proposed change in exchange rates for example could wreak havoc in markets Nevertheless more and more people are coming to believe that their daily lives cultures and social wellbeing are subject to secret decisions by faceless inter national bureaucrats These growing concerns contribute to a back lash against globalization and threaten the foundations of the global economy managed by international institutions The 1999 Seattle meeting of the World Trade Organization illus trated the difficulties encountered in the search for a solution to the democratic deficit In addition to launching the Millennium Round of trade negotiations the Seattle conclave of trade ministers was ex pected to begin a concerted effort to reform the organization and strengthen the WTOs authority over tradedispute settlement and other matters The WTO has more authority over national policies than any other international economic organization Although the IMF and the World Bank do have significant influence over less devel oped countries needing financial and other forms of assistance the WTOs authority over trade matters extends to every one of its mem bers including the United States the European Union and Japan Unlike every other international organization the WTO has the au thority to penalize and impose a monetary fine on any country that defies the decisions of its dispute settlement panels The WTOs judi cial and regulatory powers are unprecedented for an international organization It approaches the neoliberal institutionalist ideal of an effective supranational institution Moreover despite the beliefs of many Seattle protesters the World Trade Organization is the most democratic of the important interna tional institutions with the possible exception of the United Nations 382 G O V E R N I N G T H E G L O B A L E C O N O M Y General Assembly In the World Trade Organization each of the 130 or so members has only one vote the major economic powers have no formal privileged position Both the World Bank and the Interna tional Monetary Fund on the other hand have a system of weighted voting that greatly favors the United States Western Europe and to a lesser extent Japan Despite its more democratic nature the WTOs legitimacy is still questioned One of the most important demands of the Seattle protestors was that decisions of the World Trade Organization and by implication other international institutions as well be made transparent to the public In addition to openness they demanded that nongovernmen tal organizations NGOs including those dealing with the subjects of human rights labor and environmental problems should be per mitted to participate in the decisionmaking process of the WTO and other international organizations they should be permitted for ex ample to submit briefs and provide testimony regarding matters un der consideration Superficially these demands for greater democratic accountability appear reasonable If the international institutions and their decisions are to be accepted by the larger public as legitimate then greater openness and accountability may be necessary Yet there are formidable obstacles to achievement of increased openness Some international organizations are notoriously inefficient and inclusion of more participants would significantly complicate decisionmaking In addition the decisions of international organizations involve sover eign nations Making the WTOs disputesettlement mechanism more transparent for example would mean that the states who are the parties to these disputes would have to reveal sensitive information that they and powerful domestic constituents would prefer to keep secret In such a situation member governments could lose confidence in the WTO and be tempted to move outside the organization to resolve their differences Although a serious effort must be made to solve the democratic deficit achieving a solution will not be easy How does one achieve both increased efficiency and greater transparency two seemingly contradictory goals set forth by EU Trade Commissioner Pascal Lamy following the Seattle debacle The WTO is indeed undemocratic in the sense that it is not directly accountable to any electorate How ever it is difficult to envisage an electorate to which it and other international institutions could be made accountable Although the NGOs at Seattle asserted that international institutions be made ac countable to them they themselves are not accountable to any general electorate Who elected Ralph Nader to speak on behalf of all con sumers After all nearly every international regional and even na 383 C H A P T E R F I F T E E N tional organization responsible for managing our highly complex and integrated world is also characterized by a democratic deficit and is not directly accountable to a citizenry this group includes the Secu rity Council of the United Nations the International Court of Justice the World Health Organization the European Commission the US Supreme Court the Federal Reserve and such American independent regulatory agencies as the Pure Food and Drug Administration and the Security and Exchange Commission However these organiza tions as well as the WTO and other international organizations are ultimately accountable to national governments that at least in dem ocratic systems are themselves accountable to an electorate The ulti mate responsibility for governing the world has to rest with national governments at least until the peoples of the world come together in one global society Authority and Power Another important problem confronting neoliberal institutionalism and other proposals for governing the global economyis the grow ing gap between the distribution of authority within existing interna tional institutions and the international distribution of economic power When the original Bretton Woods institutionsthe IMF World Bank and GATTWTOwere established and subsequently modified authority over these organizations was in essence vested in the United States and Western Europe By custom the selection of the directorship of the World Bank has been the prerogative of the United States while selection of the head of the IMF has been the prerogative of Western Europe moreover these major powers can block any action that they disapprove Japan and the LDCs espe cially the larger ones such as Brazil and India as they have developed and gained greater economic strength have increasingly resented this arrangement and have demanded more authority and more leadership roles This issue precipitated a crisis in early 2000 regarding appoint ment of a new directorgeneral of the IMF after the resignation of Michel Camdessus as managing director Following tradition the West Europeans proposed their nominee German finance official Caio KochWeser whom they fully expected would be chosen Unex pectedly both Japan and an unusual coalition of LDCs nominated alternative candidates 6 Although the United States did not contest 6 The candidate of the coalition of African and Arab states was Stanley Fischer a distinguished American economist and highly experienced IMF official The Japanese supported by some East Asian countries nominated Eisuke Sakakibara a former high official in the Ministry of Finance colloquially known as Mr Yen in part because of his strong and outspoken criticisms of American policy 384 G O V E R N I N G T H E G L O B A L E C O N O M Y the right of the Europeans to choose the head of the IMF it raised serious questions about KochWesers qualifications Eventually the dispute was settled by the selection of an acceptable German nomi nee Horst Kohler Underlying this seemingly minor dispute was the more fundamental question of which nation or nations will control or predominate in those institutions responsible for managing the global economy 7 This issue has long divided the United States and Western Europe In this instance even though many Europeans had reservations about Mr KochWeser they especially the French regarded his candidacy as a means to prevent growing American domination of the IMF and other international institutions West Europeans have become very concerned about their diminishing position in the international eco nomic and political system German insistence that it was their turn to select the IMF head reflected their desire to be recognized again as a great power National pride is still very much with us In practice the United States has been the dominant power in the International Monetary Fund as well as the World Bank and the Gen eral Agreement on Tariffs and TradeWorld Trade Organization In the several financial crises that have afflicted the international econ omy including the 19941995 Mexican crisis and the post1997 East Asian crisis the United States in effect dictated IMF responses In the realm of trade the United States has initiated every round of trade negotiations and has largely set their agendas The United States has frequently performed this leadership role against the opposition of Western Europe Japan and other powers the United States had to put considerable pressure on Europeans even to participate in the Ur uguay Round West Europeans have also exercised inordinate influ ence in both the GATT and the WTO It is not excessive to say that the United States and Western Europe because of historical prece dents and their sheer economic strength have been and continue to be the dominant players in the international trading economy Continuing American and West European dominance in the WTO IMF and World Bank has become increasingly noxious to the Japa nese and Japan is very unhappy about its subordinate role in these institutions Although Japan is the secondlargest donor to interna tional institutions like the OECD and the IMF no Japanese has ever been chosen head of or even been seriously considered for any im portant international economic institution other than the Asian De 7 Votes in the IMF are based on a countrys financial contribution On this basis the United States has 17 percent of the votes the combined vote of the fifteen EU members is 37 percent Thus the United States and the European Union together con trol just over a majority of the votes 385 C H A P T E R F I F T E E N velopment Bank In addition Japan is very resentful over the IMFs handling of the 1997 Asian financial crisis and the way in which the IMF has operated in the region The Japanese as well as other East Asians believe that the IMF is too much under American influence In response to these concerns in 1999 Japan for the first time pro posed its own candidate to be the next directorgeneral of the IMF and sought support for that candidate from other Asian nations Ja pans new assertiveness highlights the fact that leadership of the inter national institutions responsible for managing the global economy continues to reside with the West despite the shift in the global bal ance of economic power toward nonWestern powers This disconti nuity between authority and power must one day be rectified if these institutions are to survive The longerterm significance of the Seattle meeting is that Western dominance of this international institution was successfully chal lenged by the less developed countries for the first time when they blocked major items on the agenda developed by the Americans and Europeans The Seattle conclave witnessed a new and potentially im portant development in WTO governance Led by Brazil Egypt and India the less developed countries who possess an overwhelming ma jority of the votes in the WTO were successfully mobilized Although they were not able to achieve their own agenda they did thwart the efforts of the United States to incorporate labor standards and envi ronmental protection into the trade regime The less developed coun tries discovered at Seattle that they could influence the rules governing the international economy and at least prevent adoption of new rules contrary to their interests How the LDCs will choose to exercise this newfound power in the future remains unclear The significance of the change that has taken place in the role of the LDCs in governance of the world economy may be illuminated by a brief history Throughout much of the postwar era the less developed countries have sought to achieve greater influence in international economic institutions and to make these institutions serve their interests Their first attempt to achieve such goals was a proposal at the Bretton Woods Conference to create an international development regime that would benefit the less developed countries directly This effort was spurned by the United States and the other major powers Believ ing that the world economy worked to their disadvantage many LDCs chose protectionism and began to pursue importsubstitution policies They generally left management of the international econ omy to the Bretton Woods institutions and the major economic pow ers This attitude of resignation changed dramatically following the 386 G O V E R N I N G T H E G L O B A L E C O N O M Y first oil crisis 1973 and the resultant recognition that the less devel oped countries could translate their commodity exports into political power Less developed countries then began a concerted effort to in crease their influence over the international economy The LDC revolt in the mid1970s against the major economic pow ers and their dominant position in the Bretton Woods institutions was led by the Group of 77 which demanded a New International Eco nomic Order NIEO 8 In addition to a long list of specific economic demands such as debt relief and greater access to ADC markets the Group of 77 wanted the Bretton Woods institutions to be placed un der the authority of the UN General Assembly where the LDCs have a voting majority and could force the World Bank and other interna tional organizations to implement their own economic agenda This assault on international liberalism to use Stephen Krasners formula tion was eventually defeated by the United States and other major economic powers Subsequently in the late 1970s and early 1980s the huge debt crisis of many LDCs led to another revolt but the LDCs were eventually forced to accept the dictates of the major powers The thirdand this time more successfulattempt of the LDCs to increase their authority in governance of international economic af fairs took place at Seattle in late 1999 Whereas earlier efforts to achieve the New International Economic Order andor massive debt relief had failed the less developed countries were now inside the system and had the votes needed to successfully oppose any decisions contrary to their interests including President Clintons proposal re garding labor standards One can look at this development as a vic tory for the underdog and of course it was However this victory could make management of the trading regime much more difficult One lesson of Seattle was that the WTO with its more than 130 mem bers has become a very cumbersome institution indeed The great eco nomic powers will at least have to pay much greater attention to the concerns of the less developed countries Developments at the 1999 Seattle meeting could cause the major economic powers to forsake the WTOs multilateral approach to low ering trade barriers and to conduct trade negotiations on a unilateral or bilateral basis on terms highly favorable to the major economic powers Abandonment of multilateral trade negotiations would be 8 The Group of 77 and its demands are discussed in Stephen D Krasner Structural Conflict The Third World Against Global Liberalism Berkeley University of Califor nia Press 1985 387 C H A P T E R F I F T E E N highly detrimental to the world trading system and especially to the LDCs The protesters in Seattle believed that the WTO is a prisoner of corporate interests yet they forget that the weak and not the strong benefit most from the rule of law If unilateralism and bilater alism replace the WTOs multilateralism regional trading arrange ments would undoubtedly increase and eclipse the postwar effort to achieve a multilateral trading system based on accepted rules A liberal international order requires strong leadership and cooper ation among the major economic powers and the United States is still the only nation capable of providing such leadership even though American leadership of the world economy in the last decades of the twentieth century was anything but inspiring Moreover the United States cannot lead alone Cooperation among the major economic powers is necessary and the rising economic powers of South and East Asia will need to be included Unfortunately the United States and its Cold War allies are drifting in different directions and clashes among them have increased since the end of the Cold War Many observers dismiss such concerns and argue that mutual economic in terests will ensure continuing international cooperation It is certain that the United States Western Europe and Japan do have a strong political and economic interest in cooperating with one another It is also certain that obstacles to cooperation such as attacks on global ization and intensifying economic competition are increasing This situation could become very serious in the event of economic adver sity Meanwhile American leadership and interstate cooperation con stitute the only possible foundation for an open and stable global economy In effect a fourway contest has arisen concerning who governs those international institutions responsible for managing the global economy With the waning of Cold War alliances and the increasing assertion by the United States of its superpower status both the Japa nese and the West Europeans have become more and more deter mined to counter American power in the IMF and other international economic agencies 9 Demands have also increased from a coalition of LDCs and industrializing countries who believe their interests must be better served by the IMF World Bank and WTO These countries have been energized because in recent years the IMF and other insti tutions have increased their power over these nations and this was 9 In addition to lacking influence comparable to their economic might and financial contribution to the IMF and World Bank the Japanese were particularly incensed over the Americandominated IMF approach to the 1997 East Asian financial crisis 388 G O V E R N I N G T H E G L O B A L E C O N O M Y dramatically witnessed in the role of the IMF in the East Asian and other financial crises As the authority of international institutions has grown so have the demands of more and more nations for a greater say in these institutions In addition groups and individuals with widely divergent and conflicting opinions at both ends of the political spectrum have increasingly demanded that wideranging reforms be instituted Institutional Reform Many believe that the IMF WTO and other international institu tions must be reformed in response to the changed nature of the global economy An important demand for reform has come from the United States where the IMF has been strongly attacked by both political left and right The most serious demand came in the late 1990s from the conservativedominated House of Representatives where the IMF was singled out for attack for among other charges being wasteful and antimarket In response to these concerns and as a precondition for agreement to a 1998 replenishment of IMF funds the House established the International Financial Institutions Advi sory Commission to propose changes in the IMF Under the chair manship of Alan Meltzer a respected conservative economist the Commissions report recommended to the Congress that the IMF and World Bank should be radically reformed and restructured because in its opinion these agencies frequently do more harm than good in the developing world and waste billions by making loans to middle income countries that could rely on the market instead 10 The principal recommendation of the Commission was that the IMF should curtail its lending programs to developed countries and cease intervening in the politics and economics of these countries In an era of huge international financial flows the private sector should have the responsibility to supply capital to the industrializing coun tries The majority members of the Commission argued that IMF in terventionism in developing countries to relieve poverty and espe cially IMFs implicit guarantee to assist in the event of financial trouble encouraged moral hazard and overborrowing They urged that the IMF should restrict itself to helping the very poor and those less developed countries with temporary liquidity problems more over the IMF should make only shortterm loans at market or above interest rates in order to discourage irresponsible financial behavior that is the IMFs activities should be limited to those of a lender of 10 New York Times 8 March 2000 C4 389 C H A P T E R F I F T E E N last resort The International Financial Advisory Commissions report also recommended that the World Bank which makes 50 billion of development loans a year should be renamed the World Develop ment Agency and that it too should refrain from competing against the private sector The reports critics maintain that its unstated purpose was to de stroy the effectiveness of the IMF and to a lesser extent the World Bank rather than to reform them 11 The report assumed that most of the time in a marketoriented global economy only minimal inter vention by any form of government would be required except in un usual restricted circumstances and that any intervention would be likely to be counterproductive Thus the report questions whether or not international institutions that began in the early Cold War period are appropriate to the globalized economy of the twentyfirst century In the world of huge private international financial flows what role can these international institutions usefully play Is governance really necessary or can matters be left up to the selfregulating market of neoclassical economic theory These are issues that proponents of neoliberal institutionalism as well as all other scholars of interna tional political economy must address The New Medievalism The new medievalism based on the belief that the world is experi encing the end of national sovereignty 12 implicitly rejects the idea of a liberal international economic order based on cooperation among sovereign states Set forth originally in the Treaty of Westphalia 1648 the doctrine of sovereignty asserts that governments enjoy complete control over the territory and persons within their legal ju risdiction New medievalists believe that the concept of national sov ereignty which has guided international statecraft for three hundred and fifty years is breaking down because of both internal and exter 11 There is a stinging critique of the Report in Barry Eichengreen and Richard Portes A Shortsighted Vision for IMF Reform Financial Times 9 March 2000 13 also The Economist 18 March 2000 80 Treasury Secretary Lawrence Summers who has set forth his own plans for IMF reform has also criticized the Report in The Financial Times 23 March 2000 17 12 The term new medievalism is attributed to Hedley Bull The Anarchical Society A Study of Order in World Politics London Macmillan 1977 Expressions of this position are David Held Democracy the Nationstate and the Global System Economy and Society 20 no 2 May 1991 and Jessica T Mathews Power Shift Foreign Affairs 76 no 1 JanuaryFebruary 1997 5066 390 G O V E R N I N G T H E G L O B A L E C O N O M Y nal developments states are fragmenting into substates as a result of ethnic and regional conflicts and at the same time are being eclipsed by rising nonstate and superstate actors such as multinational firms international organizations and especially nongovernmental organi zations NGOs 13 New medievalists explain that this historic watershed has been reached because of transnational economic forces trade finance etc and because of such contemporary technological developments as the computer information technologies and advances in transportation In the era of the Internet they allege that governments have lost their monopoly over information and can therefore be successfully chal lenged by nongovernmental actors Concluding that these changes erode hierarchical organizations and undermine centralized power structures they see the oncedominant hierarchic order of nation states being supplanted by horizontal networks of states voluntary organizations and international institutions This development in turn leads to cooperative problem solving by concerned individuals and groups from around the world In place of the undivided loyalty formerly owed by the citizen to the sovereign a world of multiple allegiances and responsibilities is envisioned a world in which subna tional national and supranational institutions will share authority over individuals The implications of this position for governance of the global econ omy are not clear 14 Proponents of the new medievalism assert that something new is on its way to replace the state but they do not precisely define what that something may be However one possibil ity has been set forth by Wolfgang H Reinicke in his Global Public Policy Governing Without Government 1998 15 The central prop osition of Reinickes interesting book is that government and the functions of governance can be disentangled from one another In the modern world government has referred to formal institutions that enjoy national sovereignty possess a monopoly of power over a par ticular territory and are not answerable to an external authority Governments have been able to make domestic public policy and have 13 A critique of the end of sovereignty position is Stephen D Krasner Sovereignty Organized Hypocrisy Princeton Princeton University Press 1999 14 A useful review of several ideas for global governance is MarieJosee Massicotte Global Governance and the Global Political Economy Three Texts in Search of a Synthesis Global Governance A Review of Multilateralism and International Orga nizations 5 no 1 JanuaryMarch 1999 12748 15 Wolfgang H Reinicke Global Public Policy Governing Without Government Washington Brookings Institution 1989 391 C H A P T E R F I F T E E N remained politically independent actors in international affairs Gov ernance on the other hand is a social function that is essential to a market economy at the national or international level and is not necessarily the same as government 16 Governance according to Rein icke need not be equated with government but can be achieved through networks of public and private groups or institutions at na tional regional and international levels In this fashion a global economy can gain the benefits of government without a formal gov ernment 17 Assessing the feasibility of international governance Reinickes analysis concentrates on three case studies in the areas of finance crime and dualuse technology that he believes establish the feasibil ity of international governance as he defines it One of his case studies directly relevant here is concerned with the negotiation and establish ment of the Basle Accord 1988 to develop international regulatory standards for international banks The principal component of the Accord was specification of minimum capital adequacy requirements that is it specified the size of the funds that international banks had to maintain to prevent bank failures and decrease the risk of destabi lizing crises In this case study Reinicke argues that the Accord resulted from complex and successful negotiations among national governments private interests and the Bank for International Settle ments He concludes that the Basle Accord resulted from successful cooperation among governments NGOs and international institu tions that were able to create an international governance mechanism in this particular area of international finance Although Reinickes example does illustrate that national private and international organizations can cooperate and find a solution to an economic problem his argument does not provide convincing sup port for the idea that governance as opposed to government by itself can deal with the many pressing problems created by increasing inte gration of the world economy As Reinicke himself shows the Basle Accord was achieved largely through strong American pressure American moneycenter banks in New York and California had com plained to the Federal Reserve that foreign international banks were permitted to maintain bank reserves lower than those required for American banks and that as a result the international competitive 16 Ibid 87 17 Reinickes idea of Global Public Policy Networks is set forth in greater detail at wwwglobalpublicpolicynet 392 G O V E R N I N G T H E G L O B A L E C O N O M Y position of American international banks had declined Responding to these concerns the Federal Reserve put pressures on foreign gov ernments to raise reserve requirements this resulted in the Basle Ac cord which required European and Japanese banks to increase their reserves Although it was undoubtedly desirable that a universal stan dard on reserves be established the United States clearly pressured others to accept its own banking regulations and did so in the inter ests of US domestic banks 18 This episode indicates that the problem of governing without government exists because international gover nance will not work without power and unfortunately Reinickes governance mechanism lacks the power needed to achieve compliance with its decisions A major theme of the new medievalism is that nongovernmental organizations NGOs have or at least should have a central role in the governance of international or perhaps I should say postna tional affairs Organized primarily around such specific issues as safeguarding the environment protecting human rights and promot ing a safer world NGOs are believed to have become a significant force in particular issue areas The number of nongovernmental orga nizations has greatly increased in recent decades to approximately 30000 at the beginning of the twentyfirst century 19 Among the most important of these grassroots organizations are the Worldwide Fund for Nature with about 5 million members and the Sierra Club with approximately 600000 members Most NGOs are located in the United States and to a lesser extent in Western Europe but have become increasingly active in some less developed countries Japan appears to have few important NGOs Although NGOs were initially involved primarily with domestic issues they have become increas ingly concerned over the alleged negative consequences of globaliza tion upon various international issues Moreover through the In ternet NGOs around the world have greatly improved their ability to communicate with one another As was demonstrated by the street protests in Seattle against the WTO these developments have also encouraged and facilitated formation of international NGO alliances that can bring considerable pressure on governmental agencies to change their policies 18 For a very different interpretation of the Basle Accord consult Ethan Kapstein Governing the Global Economy International Finance and the State Cambridge Har vard University Press 1994 19 The Economist 11 December 1999 21 and 29 January 2000 2527 The discus sion in this section on NGOs draws heavily from these articles 393 C H A P T E R F I F T E E N According to AnneMarie Slaughter the increasing importance of nonstate actors is due to several developments 20 The end of the Cold War has lessened security concerns and opened the way for the rise of what she calls transnational civil society In addition the infor mation economy and the Internet have made possible emergence of an international civil society because they have broken the information monopoly of corporations and governments the Internet also greatly facilitates communications among nonstate actors Finally and per haps most importantly the globalization of the economy through in tegration of financial markets enhances the power of multinational corporations and they are further integrating national economies Although there is some truth in Slaughters characterization of the present era several important caveats should be noted The security environment in Europe has improved since 1989 except for the Bal kans On the other hand the situation in South Asia has significantly deteriorated while the increasing threat of war in East Asia the Mid dle East and parts of Africa is worrisome It is far far too early to know what impact the Internet and information economy will have on either domestic or international society Will they have benign or negative consequences Some experts worry about threats to privacy improved methods of monitoring and controlling people and in light of huge corporate mergers a massive concentration of economic power In a provocative article Joseph Nye and William Owens argue that control over information will be the ultimate source of power in the international politics of the Internet age 21 Recognizing this possi bility major military establishments around the world are preparing for cyber warfare the NyeOwens prediction and these military activ ities do not accord with more benign views of the information revolu tion such as AnneMarie Slaughters Whether these two experienced foreign affairs experts Nye and Owens or the advocates of global civil society are correct remains to be seen Possible future conse quences of increasing globalization are unknown It is a mistake to consider only the benefits of economic and technological change NGOs have succeeded impressively in influencing the policies of national governments and international institutions at least in some areas One of the most important accomplishments was the Earth Summit 1992 in Rio de Janeiro where NGOs brought enough pub 20 AnneMarie Slaughter commentary in The Challenge of NonState Actors Pro ceedings of the 92d Annual Meeting of the American Society of International Law Washington DC April 14 1998 2021 21 Joseph S Nye Jr and William A Owens Americas Information Edge Foreign Affairs 75 2 MarchApril 1996 2036 394 G O V E R N I N G T H E G L O B A L E C O N O M Y lic pressure to bear to achieve a number of agreements to eliminate greenhouse gases Two years later NGO protestors besieged the World Bank and forced the latter to reconsider some of its policies Other examples of successful NGO campaigns were the treaty to eliminate land mines the agreement to reduce the huge indebtedness of many less developed countries and the derailment of the Ameri cansponsored Multilateral Agreement on Investment that would have harmonized rules on foreign direct investment Whatever one may think about the wisdom of one or another of these successes it is certain that NGOs have become a force in the contemporary world 22 However it remains uncertain whether or not NGOs can become the most effective or at least one of the most effective means to govern the global economy Although NGOs record is impressive is it cor rect to conclude that we are truly witnessing the beginnings of a movement that can transform the world Certainly evidence does suggest that in their confrontations with the American government and those of some other nations NGOs do frequently triumph NGOs can lobby and pressure national governments to heed their wishes Undoubtedly responding to their demonstrated power inter national institutions such as the World Bank have established close ties with NGOs especially those possessing technical expertise In the aftermath of the Seattle debacle pressures mounted for the World Trade Organization to open its proceedings to interested NGOs It would require a giant step however to move from efforts to increase cooperation between international organizations and nongovern mental organizations toward establishment of a global governing mechanism incorporating the growing number of NGOs 23 Neomedievalists believe that the increasing importance of NGOs in international affairs is a positive factor in the emergence of a global civil society 24 The idea of a global civil society has been set forth by many proponents of the new medievalism and a number of writ ings present it as an alternative to a capitalist nationstate world or 22 An attempt to measure the effectiveness of NGOs is Margaret E Keck and Kath ryn Sikkink Activists Beyond Borders Advocacy Networks in International Politics Ithaca Cornell University Press 1998 23 The journal Global Governance A Review of Multilateralism and International Organizations is dedicated to the idea of a governing mechanism based on civil society and incorporating NGOs 24 A wideranging and sympathetic discussion of global civic society is contained in International Affairs 75 no 3 July 1999 Also Adam Watson The Evolution of International Society A Comparative Historical Analysis London Routledge 1992 395 C H A P T E R F I F T E E N der Robert Cox has argued that civil society is composed of people and groups seeking alternatives to globalization of the capitalist sys tem He believes that global civil society and social protest move ments can provide a basis for an alternative world order 25 Many neo medievalists would agree with Coxs statement Many of those who accept this concept of a global civil society believe that the nation state has become a servant of global capitalism and should share with capitalism the responsibility for such economic and social ills as in equality environmental degradation and widespread abuses of hu man rights Similarly international regimes and institutions are viewed as following the dictates of powerful multinational firms and the international capitalist elite The emerging international civil society is said to be composed of domestic and transnational nongovernmental groups organized pri marily around strong policy concerns focusing on such subjects as the environment and elimination of nuclear weapons The nongov ernmental organizations NGOs and global social movements that constitute global civil society are strongly motivated by opposition to the alleged evils of national governments multinational firms and globalization However they themselves are a product of globaliza tion Paradoxically as was demonstrated at Seattle they could not have organized allied with one another and been politically effec tive without the revolutionary advances in global media and commu nications It is worth noting that these advances are a product of the global capitalist system that many neomedievalists so heartily condemn Consideration of the medieval model of governance suggests the magnitude of the problem faced by the neomedievalist agenda The medieval world of Western Europe from approximately the fifth to the fifteenth centuries shared a heritage of Christianity and Roman law The ruling aristocracy of each major European country shared many similar ideas norms and values Across Western Europe one found much the same social and political structures feudalism the Church and kingship Despite its continual political religious and social strife one can reasonably speak of medieval Europe as having possessed a unified civic culture This thousandyear era before the rise of the modern territorial state was also characterized by fragile and dispersed concentrations of economic and political power The 25 Robert Cox Civil Society at the Turn of the Millennium Prospects for an Alter native World Order Review of International Studies 25 no 1 January 1999 1011 396 G O V E R N I N G T H E G L O B A L E C O N O M Y level of technology and the level of organizational skills limited mobi lization and effective use of economic and military capabilities Although proponents of the new medievalism speak of the emer gence of a global civic culture of shared values and understandings that could provide social and political foundations for an NGOman aged world evidence supporting such a contention is hardly convinc ing Insofar as a postnational global civic culture does exist it is mainly limited to Western civilization yet even in the West powerful nationalistic ethnic and racial conflicts persist Despite stirrings in the nonWestern world regarding the importance of human rights toleration of religious differences and Western liberal ideals these other civilizations do not share the civic culture andor core values of the West 26 Knowledge of the history of the twentieth century makes it difficult to accept the argument of many human rights advocates that abusers of human rights will be deterred from further abusive activities because they have become subject to international exposure One need not accept Samuel Huntingtons argument in The Clash of Civilizations 1996 to appreciate that hundreds of millions of indi viduals do not subscribe to the Wests secular values nor do they accept the idea of a global civic culture incorporating religious tolera tion human rights and respect for individualism 27 In China India and other parts of the less developed world the state is certainly alive and well NGOs are very unlikely to become as influential in these cultures as they have in the United States and some other Western countries One day perhaps especially as a consequence of economic development and emergence of a strong middle class these civiliza tions may gravitate toward Western values of democracy individual ism and human rights But this time has not yet arrived It is much too soon to know what the longterm impact of NGOs will be on the management of an integrated global economy At pres ent the observer should keep in mind that the modern state has been around for over three centuries and that generally effective interna tional institutions have existed for a half century while the active era of NGO activity on an international level began only two decades ago If history is any guide one can anticipate that the highly favor able picture that we have today of NGOs will become quite different in the future It is the nature of politicsand politics is what we are talking aboutfor power to beget countervailing power and for the 26 The Economist 5 December 1998 special section A Survey of HumanRights Law 27 Samuel Huntington The Clash of Civilizations and the Remaking of World Order New York Simon and Schuster 1996 397 C H A P T E R F I F T E E N tactics of the politically successful to be imitated by others The good NGOs of our time which in most cases are pursuing note worthy objectives may one day be joined by NGOs whose goals are much less praiseworthy Such a possibility was foreshadowed by the unholy alliance in Seattle between the good NGOs seeking to achieve such selfless objectives as human rights and environmental protection with American organizedlabor NGOs that cynically ex ploited the formers goals in its campaign to keep LDC exports out of the American economy It is sobering to recognize that the Na tional Rifle Association and the Russian Mafia whose agendas do not coincide at all with the political agenda of the new medievalists have been among the most successful of all NGOs Transgovernmentalism Transgovernmentalism poses a third possibility for a rulebased inter national economic and political order Like liberal internationalism and unlike the new medievalism this position accepts the continued existence of nationstates However the nature of the state envisioned by this intellectual position is fundamentally different from that in statecentric liberal internationalism and political realism Like the new medievalism this position assumes that the governance functions of the state can be divided and delegated to intergovernmental bodies or networks dealing with specific policy issues As AnneMarie Slaughter has pointed out many transgovernmental organizations al ready exist to deal with such matters as banking regulations the Basle Accord antitrust regulation and judicial matters 28 These transna tional networks composed of technical experts business executives and lawyers are needed to manage an increasingly complex and inte grated world in which extensive technical input is required Yet it would be a large leap from transgovernmental mechanisms in specific policy areas to international governance of the globe Transgovernmentalism is a quite conscious throwback to what Robert Keohane and Joseph Nye identified in their earlier writings as transnationalism and also although to a lesser extent as neo functionalism 29 Like transnationalism and neofunctionalism trans governmentalism makes three crucial closely related assumptions re garding national governments Transgovernmentalism assumes that 28 AnneMarie Slaughter The Real New World Order 29 Robert O Keohane and Joseph S Nye Transnational Relations and World Poli tics Cambridge Harvard University Press 1972 Thomas RisseKappen ed Bringing Transnational Relations Back In New York Cambridge University Press 1995 398 G O V E R N I N G T H E G L O B A L E C O N O M Y nationstates can be divided into their component parts an idea set forth in 1971 by Graham Allison 30 The divided parts can then deal directly with their counterparts in other governments Another as sumption is that technical and other functional problems can be solved in isolation from larger national concerns and parochial politi cal matters Thus like transnationalism and neofunctionalism trans governmentalism assumes that technical issues can be separated from politics and solved independently Regulatory matters for example can be isolated from national economic priorities and from the pres sures of powerful interests Finally transgovernmentalism ignores matters of national security and foreign policy and assumes no hierar chy or priority among the issues of interest to governments National concern over the proliferation of nuclear weapons or the future of the NATO alliance is treated no differently than regulation of ocean fisheries Transgovernmentalism foresees a world stripped of power na tional interests and interstate conflict a world in which technocrats bureaucrats and the like solve issues outside the realm of politics While stressing the absolute gains from transgovernmental coopera tion transgovernmentalism is silent on the matters of relative gains and distributive questions that arise in almost every serious interna tional discussion of substantive issues Thus transgovernmentalism envisions a world nearly devoid of both domestic and international politics Transgovernmental networks can be very useful in the solution of the many issues that have arisen and will continue to arise However this approach to governance of the global economy is severely limited by the political rivalries and conflicting interests among nationstates and powerful domestic constituencies As we have already seen even such a technical matter as the Basle Accord on banking practices frequently cited as an example of successful intergovernmentalism at work was laced with intense political and economic conflicts Bu reaucrats in the Japanese Ministry of Finance were acutely aware of the crucial role of American coercive power and economic interest in the outcome of the negotiations over that Accord Any effort to re solve the governance issue must take into account the fact that we still live in a world of states power and national interests Each approach to governance of the global economy discussed above offers useful contributions As proponents of neoliberal institu tionalism correctly argue formal international institutions and agreed 30 Graham T Allison Essence of Decision Explaining the Cuban Missile Crisis New York HarperCollins 1971 399 C H A P T E R F I F T E E N upon rules or regimes have greatly facilitated cooperation among sovereign nationstates and have been a significant factor in the man agement of the international economy over half a century Yet the continued resistance of states to restrictions on their sovereignty the limited coverage of international regimesinstitutions and serious problems of compliance mean that neoliberal institutionalism alone cannot govern the global economy The argument of the new medi evalism that NGOs are becoming more important in solving the worlds pressing problems is supported by the fact that the strong commitment and concentrated energy of these associations have been on the whole positive forces for dealing with many of the worlds serious issues Yet these groups cannot function without the national governments and international institutions on which they must bring pressure to achieve their goals It is much too early to know the true longterm significance of the NGOs Finally the approach of transgovernmentalism is an important complement to the other two approaches Cooperation and informa tionsharing across national borders and among the agencies and branches of national governments can be effective means of dealing with many complex technical issues at both the domestic and interna tional levels However the legalistic and technocratic approach of transgovernmentalism not only suffers from a democratic deficit but its usefulness declines steeply as issues become more entwined with matters of national security domestic partisan politics and issues of distributive economic importance Although all three approaches can facilitate the governance of the global economy none of these ap proaches can fulfill the many demands placed upon international gov ernance Resolution of the governance issue must confront an even more fundamental issue however Governance for What Governance first and last is about the exercise of power to achieve political social and other objectives Every scheme to govern the global economy therefore must confront the fundamental question Governance for what The primary purpose to be served by the pro posed mechanisms for governance of the global economy is the first issue that must be resolved During the Cold War this issue had been resolved the purpose then was to strengthen the economies of the antiSoviet alliance and solidify the political unity of the United States with its allies With the end of the Cold War and the triumph of neoliberalism the purpose of governance seemed clear again for 400 G O V E R N I N G T H E G L O B A L E C O N O M Y most American officials business leaders and professional econo mists the purpose of governance was to facilitate free trade freedom of capital movements and unrestricted access by multinational firms to markets around the globe The global economy according to this position should be governed in accordance with the policy prescrip tions of neoclassical economics and its rules should be based on mar ket principles On April 1516 2000 the neoliberal consensus was challenged on two fronts In Washington DC thousands of protestors gathered in the streets to denounce the alleged evils of economic globalization and to demand that the IMF WTO and World Bank be made more accountable to environmental human and workers rights and to other humanitarian concerns However misguided some protestors may have been they represented millions of Americans and others who have grown worried over the alleged negative consequences of economic globalization for wages job security the environment and other concerns At the time of the Washington protests several hun dred miles to the south in Havana the Group of 77 representing the worlds less developed countries was drafting demands for a larger share of the worlds wealth and a strengthened voice in the gover nance of the global economy Unlike the protesters in Washington these countries were not opposed to globalization but rather de manded a more equitable distribution of its fruits Moreover al though both the Washington protesters and the Group of 77 de manded increased control over the global economy their social economic and political purposes were largely in opposition to one another although on some issues such as debt relief for poor coun tries increased financial assistance to LDCs and greater control over MNCs their agendas did coincide However with respect to more fundamental issues such as delegating greater authority to the WTO over environmental matters human rights and labor standards the protestors and the Group of 77 could not have been farther apart Both the Washington protestors and the Group of 77 demanded fundamental changes in the purposes to be pursued by the governing institutions of the global economy Making their respective demands they rejected an international economy based on the principles of neo classical economics and market principles whose ultimate purpose was maximization of consumer choice and global wealth In place of the exclusively economic objectives of neoliberalism they sought to substitute such nonmarket objectives as protecting the environment safeguarding the jobs of American workers or redistributing global wealth to less wealthy countries Thus the battle was joined once 401 C H A P T E R F I F T E E N again between those who desired a world governed by the market and those who wanted the market subordinated to some higher political authority that would pursue one or another social purpose Through out much of modern history this battle over the ends of economic activity has been fought principally at the domestic level between the representatives of capital and labor In the increasingly integrated global economy of the twentyfirst century the battleground has be come the entire globe and the types as well as the number of partici pants have greatly expanded to include states international organiza tions and nongovernmental organizations This is the new global economic order that those interested in international political econ omy must confront Conclusion Governance at any level whether national or international must rest on shared beliefs cultural values and most of all a common iden tity Unfortunately we do not yet live in a global civic culture and few common values unite all the peoples of the world Identity and loyalties are still national or even local ethnic and racial As more and more nations are formed national identities are becoming more numerous and in some cases more intense The value of human rights appears to be shared by many people throughout the world all governmentseven those who violate human rightsbelieve that they must at least give it lipservice Although some notable triumphs of human rights have occurred nationalistic ideals still prevail Mod ern states are highly selfcentered and are seldom concerned with the welfare of other peoples For example there is little sharing by the rich with the poor Under such circumstances talk of substituting global governance for the primacy of nationstates is in vain The best for which one can hope is that the major powers in their own self interest as well as that of the world in general will cooperate to fash 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History of Financial Crises New York Basic Books 1988 Kirshner Jonathan Currency and Coercion The Political Economy of Inter national Monetary Power Princeton Princeton University Press 1995 Krasner Stephen D Defending the National Interest Raw Materials Invest ments and US Foreign Policy Princeton Princeton University Press 1978 Structural Conflict The Third World against Global Liberalism Berkeley University of California Press 1985 407 S E L E C T B I B L I O G R A P H Y ed International Regimes Ithaca Cornell University Press 1983 Krugman Paul R Geography and Trade Cambridge MIT Press 1991 ed Strategic Trade Policy and the New International Economics Cambridge MIT Press 1996 Krugman Paul R and Maurice Obstfeld International Economics Theory and Policy 3d ed New York HarperCollins 1994 Lairson Thomas D and David Skidmore International Political Economy The Struggle for Power and Wealth New York Harcourt Brace Jovanov ich 1993 Lawrence Robert Z Albert Bressand and Takatoshi Ito A Vision for the World Economy Openness Diversity and Cohesion Washington DC Brookings Institution 1996 Lindblom Charles E Politics and Markets The Worlds Political Economic Systems New York Basic Books 1977 Little Ian M D Economic Development Theory Policy and International Relations New York Basic Books 1982 Loriaux Michael et al Capital Ungoverned Liberalizing Finance in Inter ventionist States Ithaca Cornell University Press 1997 Maddison Angus The World Economy in the 20th Century Paris Develop ment Centre of the Organization for Economic Cooperation and Develop ment 1989 Mankiw N Gregory Principles of Economics New York Dryden Press 1998 Mansfield Edward D Power Trade and War Princeton Princeton Univer sity Press 1984 Effects of International Politics on Regionalism in World Trade In Kym Anderson and Richard Blackhurst eds Regional Integration and the Global Trading System New York St Martins Press 1993 Mansfield Edward D and Helen V Milner eds The Political Economy of Regionalism 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University of Chicago Press 1998 RisseKappen Thomas ed Bringing Transnational Relations Back In Cam bridge Cambridge University Press 1995 Rodrik Dani Has Globalization Gone Too Far Washington DC Institute for International Economics 1997 Ruggie John Gerard Winning the Peace America and World Order in the New Era New York Columbia University Press 1996 Ruigrok Winfried and Rob van Tulder The Logic of International Restruc turing London and New York Routledge 1995 Scherer F M International HighTechnology Competition Cambridge Harvard University Press 1992 Schott Jeffrey J ed The World Trading System Challenges Ahead Wash ington DC Institute for International Economics 1996 Schumpeter Joseph A Capitalism Socialism and Democracy New York Harper and Brothers 1942 Shaw Martin Global Society and International Relations Cambridge Polity Press 1994 Smith Adam An Inquiry into the Nature and Causes of the Wealth of Na tions New York Modern Library 1937 1776 Snidal Duncan The Limits of Hegemonic 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Cliffs NJ PrenticeHall 1996 Waltz Kenneth N Theory of International Politics Reading Mass Addi sonWesley 1979 Reflections on Theory of International Politics A Response to My Critics In Robert O Keohane ed Neorealism and Its Critics New York Columbia University Press 1986 Weiss Linda The Myth of the Powerless State Ithaca Cornell University Press 1998 Weiss Linda and John M Hobson States and Economic Development A Comparative Historical Analysis London Polity Press 1995 Whalley John and Colleen Hamilton The Trading System after the Uruguay Round Washington DC Institute for International Economics 1996 Williamson John and Chris Milner The World Economy A Textbook in International Economics New York New York University Press 1991 Winham Gilbert R The Evolution of International Trade Agreements To ronto University of Toronto Press 1992 Young Oran R International Cooperation Building Regimes for Natural Resources and the Environment Ithaca Cornell University Press 1989 Zysman John Governments Markets and Growth Financial Systems and the Politics of Industrial Change Ithaca Cornell University Press 1983 410 Index A Bretton Woods institutions 83 384 386 Bretton Woods System 86 237 241 Abramovitz Moses 142 332 adjustment process of monetary 245 250 251 315 359 380 Buchanan James M 28 29 24445 AFLCIO 228 229 Bundesbank 170 bureaucracy 15960 191 agglomeration process of monetary 143 144 Allison Graham T 399 C American Scientists and Nuclear Weap ons Policy Gilpin 71n Cable Vincent 363 capital defined 62 63 See also human Amsden Alice 317 318 antitrust policy See competition anti capital capitalism 14 158 195 alliance 319 trust policy Arrow Kenneth 70 criticism of 368 crony 330 de mocracy and 72 developmental Arthur Brian 118 Asian model of economic development state 149 15668 174 175 and financial crises 266 global 7 interna 330 See also East Asia tionalmonopoly 249 287 manage rial 151 marketorientedregulatory B state 15056 162 174 175 propri etary 151 shareholder stockholder Baker James 314 balance of payments 243 244 246 vs stakeholder 156 175 188 see also Japan social market 16874 315 Baldwin Robert E 96 97n welfare state 169 188 368 capitalist imperialism 291 315 bankindustry alliances 187 188 190 banksbanking system 39293 German Carr E H 100n Caves Richard 281 284 16973 187 188 Japanese 165 166 190 373 reserve requirements chaebol 319 Challenge of Global Capitalism The of 372 373 See also interest rates World Bank WB World Economy in the 21st Century The Gilpin xii 203n Barro Robert J 329 Basle Accord 1988 275 392 399 Chandler Alfred D Jr 177 281 285 Becker Gary 51 329 Berger Suzanne 186 chaos theory 58n child labor See labor standards Bhagwati Jagdish 218n Big Push strategy of the 309 China 42 177 179 227 293 397 con trols placed on capital movements in Birdzell L E Jr 13132 178 borrowing sovereigngovernment 313 249 371 FDI in 290 293 transi tional economy in 333 334 Brazil 269 270 320 411 I N D E X circular and cumulative causation constrained optimization doctrine of 5152 308 312 Clinton Bill 231 269 270 request for constructivism 1920 consumer protection 152 fast track authority 22526 Clinton Administration 231 26971 containment doctrine 21 contested markets theory of 133n 302n 330 codetermination law of 169 practice convergence economic 184 Japan and 18486 18892 trend toward 296 299 of 188 system of 171 Cold War 5 11 21 42 43 80 101 convergence theory 11011 116 183 92 335 247 400 collapseofthestate position 336 convergent and divergent economic growth 14147 337 collective action problem 318 Cooper Richard N 37778 cooperation 8991 command economies 178 common market 343n core economies 122 coreperiphery structure of economy communism 21 150 195 33536 communist economies former See transi 5657 118 12022 14245 corporate aggrandizement 302 tional economies comparative advantage 206 208 284 corporate alliances See transnational alli ances 85 lawprinciple of 48 56 62 79 105 117 122 156 198 347 limita corporate governance and private busi ness practices 130 150 in American tions of conventional theory of 291 92 and oligopolisticimperfect compe system of marketoriented capitalism 15556 in German system of social tition 212 shift from competitive advantage to 197 21014 See also market capitalism 17074 in Japa nese system of developmental capital HeckscherOhlin HO model comparative statics method of 5760 ism 16468 corporate planning 295 competition globalization transnational alliances and intensified 137 impor corporate takeovers 174 corporations 34 responsibility to share tance of 152 181 between nations 18083 perfect 114 120 123 by holders 34 See also multinational cor porations MNCs small countries 304 See also oligopo listicimperfect competition corporatist capitalism 169 cosmopolitan stance 67 competition antitrust policy 163 193 303 purpose 224n See also oligopo Council of Economic Advisors 69 counterfactual argument definition of 91 lyies competitive advantage 197 21014 Cox Robert 396 creative destruction 131 competitive equilibrium model of 5253 crisis of governability 336 cumulative causation circle of 308 312 competitive state 183 competitiveness 182 defined 182 inter currencyies national 35 many vs fewsingle 25455 25759 See also national 130 132 181 212 competitiveness strategy 18081 exchange rates international monetary system concessions 219 conditionality 313 customs union 343n confidence credibility 24748 conservatism 66 67 D conservative bias in economics 67 conservatives 66 153 David Paul 118 debt crisis of 1980s 31316 constant returns 120 412 I N D E X debtfinanced growth strategy 374 East Asian financialeconomic crisis 11 232 26771 32931 deflationary debt relief of LDCs 230 decision making See rational choice consequences of 245 impact of Mexi can financial crisis on 273 impact on deep integration in global economy 320 deflationary policy 244 Japan 189 International Monetary Fund and the 64 386 Minskys deindustrialization 180 democracy 65 72 184 model and 266 neoliberalism and 306 opposition toward IMF during democratic deficit 38184 400 deregulation 6 8 189 191 285 315 316 transparency informationgather ing and 274 derivatives financial 67 Deutsch Karl W 351n East Asian Miracle Project 32223 32829 World Development Report Deutsche Bank DB 173 developing countries convergence on 32327 East Asian Newly Industrializing Coun among and conflict between developed countries and 14546 See also less tries NICs 18485 Eastern Europe 187 293 316 338 developed countries LDCs development economics rise and demise econometrics 63 economic activityiesaffairs distribu of 3059 development theory 307 high 328 tion of 7880 goals of 41 interpreta tions of 31 40 purpose of 12 23 developmental state 200 33031 fu ture of 33133 theory of 306 316 24 150 198 economic actors nature of 3334 see 22 World Development Report on 324 See also East Asian Miracle also multinational corporations economic analysis conventional 6061 Project diminishing marginal utility principle of vs political economic analysis 3536 39 52 diminishing returns 113 115 law of Economic and Monetary Union EMU 257 48 54n 55 109 discount rate 37172 economic approach to human behavior 28 distributive justice 67 92 division of labor international 79 105 Economic Approach to Human Behav ior The Becker 51 13738 dollar American 23638 25557 See economic change crucial determinants of 75 also exchange rates dollar overhang 257 economic development 4 global process of 144 stages of official thinking dollarization 25859 dolphins protection of 226 229 about 33233 and the state 3056 33940 timing of 17677 See also Dore Ronald 186 Doremus Paul N 298 development economics economic freedom 132 dumping 215 220 231 social 228 Dunning John N 28384 economic growth theory of convergent and divergent 14147 economic integration See regional inte E gration economic laws 5354 ecommerce 372 emoney 37273 economic performance national mea sures of 176 Earth Summit 1992 39495 East Asia 11 3133 138 179 See also economic policy goals of 370 economic research fundamental purpose Newly Industrializing Economies NIEs specific countries of 50 413 I N D E X economic theories and hypotheses 12 European Single Market Act 1986 341 342 6364 falsifiability of 62 63 economic union 343n European Union EU 231 232 exchange rate instabilityvolatility 240 economics classical 310 defined 25 26 48 51 66 intellectual limitations 41 248 Exchange Rate Mechanism ERM 35 of 6069 science of 40 as universal social science 5154 as valuefree 30 37 263 exchange rate uncertainty 251 Economics of Interdependence Cooper 378 exchange rates 23436 25051 37071 economies lowwage 2035 national see national systems of political econ exchange rates fixedstable 315 370 376 arguments for 25253 end of omy of scale see scale economies economists elevated status since World 23839 exchange rates flexible floating 251 War II 6970 neglect of sociopoliti cal aspects of public affairs 7173 252 376 arguments for 25355 exportled growth strategies 315 317 and public policy 6974 economy definitions and meanings of 318 320 324 342 exports 162 168 growth and 318n 3133 40 embeddedness of 4145 nature of an 3841 shift from seller to buyerorientedmarket 335 F efficiency economic 158 Eichengreen Barry J 9496 25455 factor accumulation and exogenous growth 132 ElAgraa Ali M 343n Eliasson Gunnar 18283 factor endowmentsfactor proportions model of economic growth 206 embeddedness of economy 7475 employment problem of 15152 158 FactorPrice Equalization Theorem 207 fair economic behavior 4142 endogenous growth theory See new growth theory fairness 160 See also labor standards Federal Reserve 153 179 269 369 endogenous trade theory 202 endogenous vs exogenous factorsvari 37173 39293 and debt crisis of 1980s 31314 instruments for influ ables 27 4950 5758 7576 environmental issues 22627 229 230 encing monetary supply 37172 federalism 349 367 epistemic community 86n Feldstein Martin 3132 financial crisises nature of 26367 equilibrium 55 defined 55 vs disequi librium 5559 fullemployment See also East Asian financialeconomic crisis 31011 model of competitive 5253 Nash 134 135 See also balance of financial globalization 67 financial instability theory of financial payments Pareto optimality equityefficiency tradeoff 67 crises 26466 financial revolution of mid1970s 261 equityequality vs freedomliberty 6566 and monetary affairs 23942 financial system purpose of 234 establishment right of 301 euro 25557 firm size law of increasing 287 firms law of uneven development of Eurodollar market 234 23940 European Common Market 347 287 as pricesetters vs pricetakers 114 132 European Economic and Monetary Union EMU 346 370 firstmover advantagestrategy 215 216 European Economic Community 220 European Monetary System EMS 255 Fishlow Albert 342 414 I N D E X Fordism 136 Gerschenkron Alexander 176 GlassSteagal Act 172 foreign direct investment FDI 4 7 209 advantages in ownership and in global civil society 39496 global economy creation of xi 513 ternalization 284 explanations of 27989 growth of 289 historical 42 dynamics of 3538 as embedded in larger sociopolitical systems 42 changes in 29293 integration of trade and 20910 international re fragmented 294 global firms and the borderless 29597 national economy gime for MNCs and 300302 in LDCs 28990 principal effect of as predominant economic entity in 299300 See also specific topics 28081 France 176 global political economy defined 17 18 See also global economy political freerider problem 90 free trade 45 67 79 101 debate over economy globalization economic and political 3 198202 219 economists support for 181 196 imperialism of 43 See 5 186 294 363 alleged conse quences of 36669 convergence and also trade liberalization free trade area 343n 184 critics and criticisms of 910 12 36769 high costs of 9 histori freedomliberty vs equalityequity 6566 cal perspective on 37576 and inten sified competition and transnational al Frey Bruno 96 Friedman Milton 6162 266 27273 liances 137 29596 of international finance 26164 limited nature of Full Employment Act 69 151 fullemployment equilibrium 31011 36466 triumph of 36 297 gold standard 235 236 238 246 247 functionalism and neofunctionalism 34953 transgovernmentalism and 24950 252 375 governance vs government 392 pur 39899 poses of 400402 See also corporate governance G governed market theory of 319 governing the global economy 1112 G7 270 276 Galileo Galilei 47 97102 37779 402 government in American system of mar game theory 78 79 8991 13234 214 GATT General Agreement on Tariffs ketoriented capitalism 15255 assist ing firm to establish monopolyoligop and Trade 8 192 21823 341 342 GATTWTO 197 219 380 384 oly 125 vs business 153 in German system of social market capitalism geoeconomics 181 geographic distribution of international 16970 influence on domestic econo mies 12932 intervention in econ division of labor 105 geography role in economic theory omy 29 68 72 130 146 150 151 153 in Japanese system of develop 108 See also new economic geogra phy NEG mental capitalism 15864 government failure 29 68 Geography and Trade Krugman 117n 121n Gowa Joanne 101 101n Great Britain 3537 94 1012 German system of social market capi talism 17075 187 Great Depression 98 376 greenfield investment 278 Germany 19 37 156 187 298 bank ing system 16973 187 188 corpo greenfield plants 284 Greider William 13n rate law 174 industrial system 172 73 regional leadership and integration Grieco Joseph M 79 356 Grossman Gene M 61 213 in 356 415 I N D E X Group of 77 401 industrialization 159 17273 timing of 172 growth theory See new growth theory industry world shift in distribution of 1011 H infant industry protection 16364 199201 Haas Ernst 349 351 353 Haggard Stephan 342 inflation 248 251 information importance of 6061 harmonization of national differences 19294 of national practices 18384 trade of 78 information economy 10 187 harmonyofinterest doctrine 66 Hart Jeffrey 177 insolvency crisis definition of 275 institutional reform 337 38990 Hawtrey Ralph G 2223 HeckscherOhlin HO model 122 institutionalism new 89 345 institutions 83 explanations for the cre 2069 284 basic problem with 207 hegemonic stability theory HST 84 ation of 39 role in determining eco nomic behavior and outcomes 39 93100 Heilbroner Robert L 30 role in outcome of economic activities 1057 Heller Walter 6970 HelmsBurton Act 302 interdependence economic 8081 99 convergence theory and 184 nonsym Helpman Elhanan 61 115 213 Hirschman Albert 81 82 310 312 metrical and political aspects of 81 82 sensitivity vs vulnerability of history and economic explanations of events 59 role in economic theory 8182 interest rates 37173 108 Holmes Stephen 333 intergovernmentalism 35456 international civil society 39496 human capital 114 185 concept of 6263 208 as key to economic international cooperation theories of 8990 See also governing the global growth 11617 human rights See labor standards economy international division of labor 79 105 Hume David 78 Huntington Samuel 397 13738 international finance controversy over Hymer Stephen 28688 regulation of 27177 partial global ization of 26164 I international monetary affairs reform of 25055 immigration 36566 imperialism capitalist 291 315 eco International Monetary Fund IMF 64 230 236 272 authority and power nomic 26 27 43 74 75 200 import protection 12425 See also in 38586 codes of conduct and sur veillance 27475 creation of 235 trade protectionism import substitution strategy of 308 criticism of 27273 as lender of last resort 27476 reform of 38990 309 312 315 342 income inequality 203 304 See also strengthening the 27376 transforma tion of the role of 31516 transpar wealth distribution of individualism 2627 184 methodologi ency of and data gathering by 274 International Monetary FundWorld cal 26 5152 industrial organization theory of 107 Bank IMFWB meetings 26970 288 industrial policy 154 161 201 industrial revolution new 10 136 140 international monetary system 23435 25960 devising 24850 embedded See also technological developments 416 I N D E X technical and political issues regard Japanese Ministry of International Trade and Industry MITI 157 16163 ing 24248 postwar 87 88 234 38 purpose and objectives of 234 Japanese political economy deregula tion reform and restructuring of 250 272 rulebased 241 unity vs fragmentation of 25558 18991 Japanese trade intra vs interindustry international political economy IPE 3 4 interdependence of 8082 study 209 Johnson Chalmers 16162 of 4041 7778 international regimes compliance with Johnson Lyndon 6970 Julius DeAnne 290 8893 content of 8788 defined 83 distributive functionconsequences of 8788 origins of 86 politics of K 8286 International Trade Organization ITO Katzenstein Peter 177 keidanren 15556 218 investment importance in human capi keiretsu 155 16668 176 vs Ameri can business structure 149 bank sys tal 112 investment rate 113 tem and 190 and foreign takeovers 168 241 formation of 163 horizon investment regimes international 3012 characteristics of successful tal vs vertical 166 importance of 163 166 unraveling 189 301 irreconcilable trinity 24849 251 Kennan George 21 Kennedy Round 220 370 Italy 36 Keohane Robert O 71 72 8182 84 143 353 398 Kester Carl 167 J Keynes John Maynard 46 250 310 Keynesian economics 6970 151 310 Japan 19 3132 102 180 303 banks banking system in 165 166 190 311 Kindleberger Charles P 9899 266 373 competition and trade with United States 180 controls over knowledge as separate factor of produc tion 113 213 international finance 276 277 convergence and 18486 18892 knowledgecreation activities investment in 114 economic problems of 18889 har monization and 19294 industrial KochWeser Caio 38485 Kohli Atul 329 policy in 16164 industrial relations system in 165 institutional change in Komiya Ryutaro 163n Korea South 381 18889 market economy 5657 supercompetition in 212 system of Krasner Stephen 99 387 391n Krugman Paul R 73 121n 280 281 developmental capitalism 15668 174 175 system of lean produc on capital controls 276 criticism of national competitiveness 18081 on tion in 131n and World Bank 322 development theory 328 and East Asia 321 328 on economic geogra JapaneseAmerican economic tension 160 phy 117n Geography and Trade 117n 121n on models 50 Japanese corporate strategy 16667 Japanese firms 156 159 165 212 298 300 L Japanese Ministry of Finance MOF 152 162 190 191 300 labor migration 36566 barriers to 366 417 I N D E X labor standards 225 22729 231 marketdominated international econ omy shift from statedominated to lean production 131n 136 137 293 89 marketdriven regional integration learning by doing 115 124 lender of last resort 274 34243 market economy in Japan 5657 190 Leontief paradox 208 Leontieff Wassily W 62 208 92 shift to 335 See also transitional economies less developed countries LDCs 329 borrowing technology of 11011 cur market failures 29 68 15355 310 318 rencies of 259 debt crisis of 313 315 debt problems of 263 develop market forces triumph of 294 marketoriented capitalism 15052 ment economics and 305 3079 321 328 FDI in 28990 labor stan 15556 162 174 175 economic role of government in American system of dards environmental issues and 22830 neoclassical economics and 15255 marketoriented positionapproach 273 31112 See also developing countries neoliberal institutionalism authority 316 market share vs profit maximization power and specific topics Lewis W Arthur 307n 16667 marketization 33839 liberal international economy 82 85 88 94 99101 markets beliefs in the primacy of 279 as embedded in larger sociopolitical liberal societies 150 liberalism 13 14 6566 100 embed systems 41 as inherently political 44 nature of a 5457 reliance on the ded 98 liquidity 24647 274n 314 27273 Marshall Alfred 2526 133 liquidity crisis definition of 275 List Friedrich 200201 Marx Karl 14 Marxism 13 34 location theory 29192 Lucas Robert 108 115 Marxist theory of economic and political integration 346 mass production 136 M Mayall James 45 McCracken Report and committee 71 Maastricht Treaty 1991 35 37 Macintosh vs personal computers PCs 72 Meiji Restoration 1868 157 158 11920 macroeconomic policy basic tools of mercantilism 4243 78 181 See also neomercantilism 369 effectiveness of 36974 Malaysia 381 mercantilist attitude 219 merger movement 302 managed trade 19293 210 management separation from owner Mexican financial crises of 1982 313 of 19941995 263 273 274 ship 151 managerial school 88n Mexico 292 migration 36566 mania stage 265 manufacturing flexible 293 Milberg William 30 Millennium Round of trade negotiations manufacturing industries 12526 vs service industries 216 22425 382 Minsky Hyman 26466 marginalitymarginal utility 5253 market conforming economic develop misery index 176 Mitrany David 350 351 ment strategies 317 320 323 Mittelstand 171 418 I N D E X monetary discipline 72 See also globalization triumph of economic globalization over 36 monetary integration complete 25455 monetary policy See international mone national autonomy 247 vs interdepen dence 8082 tary system macroeconomic policy monopolies 68 125 28283 facilitated National Bureau of Economic Research NBER 31 by government 125 See also capital ism internationalmonopoly National Economic Council 180 national economies importance of monopoly rents 124 283 Moore Mike 231 299300 national identity 2021 moral hazard problem of 272 273 276 330 389 national prestige 44 national savings 168 Moravcsik Andrew 35455 Morgenthau Hans J 1517 national security economic affairs and 2223 44 Morrow James D 89 multiequilibria 134 National System of Political Economy List 201 Multilateral Agreement on Investment 395 national systems of innovation 116 13032 multinational corporations MNCs 4 7 8 279 304 business economists national systems of political economy 3 130 14849 195 convergence and 28182 criticism of 291 debate over 294300 defined 278 Dun among 18392 differences among 14950 harmonization among 192 nings and the Reading Schools eclec tic theory of 28385 287 establish 94 internal characteristics of 21112 mutual recognition among 19495 ing subsidiaries 194 integration of trade and FDI by 20910 and the in relative superiority among 17580 significance of differences among ternational economy 28992 294 95 international regime for FDI and 17475 national treatment principle of 301 300302 Japanese 32 mainstream economists and 27981 Marxistradi nationalism 1315 20 145 and trade protection 200201 cal theories regarding 28688 and the nationstate 297300 nature of negotiations international 183 184 See also harmonization 3334 Porters strategic theory of 28586 statecentric interpretation of neoclassical production function 109 neoclassical economics 23 34 38 be 28889 threat posed by 3024 trade management organization of produc havioral assumptions of 311 change and 1046 discipline of 4654 dis tion and 137 Vernons product cycle theory of 28283 equilibrium and 58 limitations of 103 104 Mundell Robert A 249n 253 Mundell equivalency 207 210 27980 neoclassical economists 41 neoclassical growth theory 10911 MundellFleming model 249n mutual recognition 184 132 criticisms and limitations of 11113 Myrdal Gunnar 308 mystical approach 322 neoclassical institutionalism See neoinsti tutionalism neofunctionalism See functionalism and N neofunctionalism neoinstitutionalism 28 29 3940 91 353 Nader Ralph 152 Nash equilibrium 134 135 neoliberal institutionalism 37984 38990 401 authority power and nationstates 4 8 22 40 80 291 294 in global economy 36263 376 38489 419 I N D E X neoliberalism 306 defined 306n tri oligopolyies 284 291 facilitated by government 125 and market power umph of 306 30913 neomercantilism 157 190 in economic outcomes 13235 See also competition antitrust policy New American Economy 179 New Deal 66 151 keiretsu Olson Mancur 9697 147 new economic geography NEG xixii 11722 See also new economic theo one price law of 365 opportunity cost concept of 49 ries New Economic Paradigm 176 optimum currency area OCA 346 optimum tariff definition of 125n new economic theories 1034 108 12728 world view of the 1068 Organization of Economic Cooperation and Development OECD 7172 new growth theory xixii 11217 322 background regarding 10911 Organization of Petroleum Exporting Countries OPEC 234 240 critics of 11415 economic funda mentals and 327 emphasis on human Ostry Sylvia 301 capital 11617 implications for eco nomic policy 11516 implications P for nature of economy 113 116 limi tations of 11112 See also new eco Pacific Asia See East Asia Page John 322 nomic theories new medievalism 39098 Pareto optimality 6869 path dependence 59 11819 213 New Protectionism 97 102 197 220 221 241 360 political actors using their power to in fluence market outcomes 44 new trade agenda 22530 new strategic trade theory STT xi political economic analysis vs economic analysis 3536 39 xii 1067 12227 21417 neoclassi cal critique of 12627 See also new political economists 12 and the MNC 28689 economic theories new trade agenda Newly Industrializing Economies NIEs political economy definitions and con ceptions of 25 27 2931 45 histori 306 316 31721 323 Nixon Administration 238 cal perspective on the term 2526 3031 neoclassical economics com nongovernmental organizations NGOs 383 39198 400 pared with 39 7475 new 2830 345 study of 40 See also global polit North Douglass C 29 130 North American Free Trade Agreement ical economy political economy approach 12 38 NAFTA 195 205 206 344 Nye Joseph S 8182 143 394 398 Political Economy of International Rela tions The Gilpin xi xii 34 14 18 143n O political union 343n politics and international economics Obstfeld Maurice 280 Ohmae Kenichi 29596 6768 81 37779 402 Politics Among Nations Morgenthau oil crisis of 1973 5860 234 313 387 oligopolisticimperfect competition 115 15 16 pork barrel politics 154 155 120 215 comparative vs competitive advantage and 212 development the Porter Michael E 21113 285 299300 ory and 328 and economic regional ism 36061 new economic theories positive externalities 216 217 See also spillovers and 1067 115 12324 132 vs perfect competition 12324 134 postcommunist societies See transitional economies trade theory and 21417 420 I N D E X postindustrial societies See service econo relative and absolute gains 78 79 rentseeking behavior 27 29 mies poverty vicious cycle of 308 312 See research and development R D 11214 147 154 217 also income inequality wealth preemptive investment strategy of 125 reserve requirements of banks 372 373 216 pricespecie flow mechanism 57 78 resource allocation efficient economics as science of 66 78 price stability vs instability 248 Prisoners Dilemma 8990 219 360 retreatofthestate doctrine 331 returns to scale constant vs increasing privatization 33738 product cycle theory of foreign direct in 109 Ricardo David 48 79 vestment Vernons 211 28283 product diversification 135 Robbins Lionel 26 53 Rodrik Dani 331n 332n production function theory of the 105 productivity growth 182 Romer Paul M 108 114 115 Rosenberg Nathan 13132 178 profit maximization 16667 profit shifting 216 217 RosensteinRodan Paul N 309 Russia 268 273 See also Soviet Union publicchoice school 2829 39 public goods 100 S R Samuelson Paul 5859 310 scale economies 1067 113 115 123 rational choice economics as science of 4851 124 215 development theory and 328 interaction of transportation rational choice model of behavior 5152 costs and 121 internal vs external 328n 360n rational choice theorymethodology 26 27 5152 76 scarcity choice under conditions of 4851 rational expectations theorydoctrine of 73 Schotter Andrew 87 Schultz Theodore W 311 Reagan Administration 223 realism See statecentric realism Schumpeter Joseph 75 76 Second Regionalism xi reciprocity general vs specific 19294 21820 security dilemma 342 seigniorage 237 243 24647 reference range system 241 250 251 regime theory 8485 See also interna Sen Amartya 329 sensitivity interdependence 8182 143 tional regimes regional concentration and diffusion service economies 138 204 Single Market Act See European Single 121 143 293 regional integration 34144 361 eclec Market Act 1986 Slaughter AnneMarie 394 394n 398 tic approach to 35861 economic the ories of 34448 political theories of Smith Adam on political economy 25 The Wealth of Nations 25 198 34858 types of 34244 regional trade agreements RTAs 341 social welfare 92 152 156 158 228 Solow Robert 115 328 regional trade barriers 348 regionalism 361 growth of xi 4 11 sovereign borrowing 313 sovereignty doctrine of 390 national 97 29394 new 221 341 welfare ef fects of 347 writings on 341n 39091 Soviet Union 94 collapse of 313 totali regionalization 29294 Reich Robert 296 tariancommunistauthoritarian iden tity of 21 See also Russia Reinicke Wolfgang H 39193 421 I N D E X spatial organization of economic activi technologyies 56 availability and effi ciency of specific 119 globalization ties 105 Special Drawing Rights SDRs 237 of 292 hightechnology industries 126 marketing of 11920 neoclassi specialization economic 56 spillovers 68 216 351 See also posi cal growth theory and 111 restricted access to leading 13839 as separate tive externalities Stanislaw Joseph 362 factor of production 113 technonationalism 108 139 statecentric position and analysis 69 78 79 99 294 298 299 Tobin James 276 Tobin tax 270 statecentric realism 1423 34 92 ap proach to economic and political inte Tokyo Round of trade negotiations 192 220 gration 35658 static equilibrium See equilibrium total factor productivity 111 trade internationalglobal 5 and the Stiglitz Joseph 75 333 Stopford John M 294 economy 2026 expansion of 6 inte gration of foreign investment and StoplerSamuelson theorem 207 208 Strange Susan 85 94n 294 374 20910 intrafirm 210 289 290 298 misunderstandings regarding strategic trade theory STT See new strategic trade theory STT 2023 rise of intraindustry 2089 See also comparative advantage new structural adjustment doctrine of 306 31416 332 335 policy of 314 trade trade liberalization 101 hegemony and structural power 85 supply and demand law of 54n 5556 95 history of 19798 politics and 98 19798 positive and negative con systemcentricsystemic realism 16 sequences of 185 198 See also free trade T trade negotiations multilateral 342 See also Uruguay Round tariffs 199n 216 22122 postwar agreements to lower 220 tradepayments surplus 78 182 203 24446 29697 technological competition 21314 technological developments 8 10 trade protectionism 136 145 194 196 economic decline and retreat into 17677 and international competitive ness 13536 and international divi 146 Great Britain and 101 history of American 19697 Japan and 102 sion of labor 13738 technological innovation 105 1078 negative effects of 19899 new indus trial powers exporters of manufac 13536 and borderless global econ omy 296 and economic growth 110 tured goods and 97 rationale for and benefits of 199202 as rentseek economists treatment of 61 impor tance of national systems of innova ing behavior 27 30 strategic trade theory and 126 technology and 296 tion to 13132 lowwage countries and 2045 new growth theory See also free trade New Protectionism trade regime postwar 197 21721 and 113 organization of develop ment sociopolitical relationships in 23233 trade theory endogenous 202 economy and 131 organization of production and 13637 significance trade theory conventional 6263 revi sions of 20617 See also new strate for comparative advantage 105 technological leadership intensified com gic trade theory STT trading states 19 petition for 14041 technological leapfrogging 13940 trading system 19698 23233 transgovernmentalism 398400 technological revolution 367 422 I N D E X transition theories 33437 Washington Consensus 31415 321 wealth distribution of 6667 7880 transitional economiessocieties 36 33339 89 150 291 wealth creation emphasis on 150 transnational alliances 29596 299 globalization intensified competition 151 welfare state capitalism 169 188 and 137 transnational civil society 39496 368 welfare system 92 transnational firms See multinational corporations MNCs Whalley John 221n Wood Adrian 205 Triffin Robert 231 trilemma 24849 251 370 World Bank WB 230 322 333 meet ings with IMF 26970 288 reform Tullock Gordon 28 29 Twain Mark 363 of 389 390 selection of directorship of 38485 transformation of role of 31516 World Development Report U 1991 322 32327 World Develop ment Report 1997 331 332 underdevelopment principal source of 311 World Federalist movement 349 World Trade Organization WTO 161 unemployment 158 trade and 2056 unemployment rate 73 192 21819 creation of 197 222 and democratic deficit 38284 new uneven development law of 287 United States economy transformation trade agenda and 22530 November 1999 Seattle meeting and protests of 179 Uruguay Round 197 300301 342 22931 288 38183 38688 395 396 398 uni vs multilateralism WTO and 22124 388 Uruguay Round and 22124 See also GATTWTO V World War II 376 See also interna tional monetary system postwar Vernon Raymond 211 28283 Vietnam War 238 trade regime postwar Viner Jacob 22 34648 356 vulnerability interdependence 8182 Y 143 Yergin Daniel 362 W Z Wade Robert 177 317 319 Waltz Kenneth 16 80 zaibatsu 166n zerosum competition 180 See also War and Change in World Politics Gil pin 18 game theory 423