The globalization paradox

Dani Rodrik argues that the ultimate paradox of globalization is that it works best when it is not pushed too far. This paradox must be reflected in new global economic arrangements that are based on democratic deliberation where it really occurs – within national states.

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Let me begin by framing my argument with three key ideas. One is the idea that markets need to be coterminous with institutions of governance and regulation that underlie them. This is a corollary to Adam Smith’s notion that the division of labour is limited by the extent of the market. My corollary is the idea that the extent of the market is, in turn, limited by the scope of workable, and I emphasize workable, regulation and governance. A lesson that we keep learning is that markets are institutions that require the support of other non-market institutions. Any kind of long-distance market requires non-market institutions to create it. Markets are not self-creating, they’re not self-regulating, they’re not self-stabilizing, and they’re not, fundamentally, self-legitimizing.

That is why well-functioning domestic markets always operate amidst an alphabet soup of regulatory institutions that deal with market failure, with informational asymmetries, and with incentive problems. The requisite rules are embedded in macroeconomic institutions – institutions of monetary and fiscal stabilization – and in broader governance, in political institutions that also provide safety nets, social protection, the welfare state, and ultimately, of course, in political democracy, in terms of ensuring that markets operate within a set of rules that operate through legitimate modes of public choice. So, the first key idea is that we run into problems when markets go beyond the limits of the governance institutions that we need to support them.

Governance

The second idea is that the main locus of legitimate governance today remains the nation state. There is a lot of creative new thinking about mechanisms of governance that go beyond the nation state: various mechanisms of global governance, whether those are the traditional multilateral or international organizations, along the lines of the International Monetary Fund and the World Trade Organization (WTO), or the newer forms of ‘network’ governance around networks of regulators; or the various forms of cross-border, non-governmental organizations; or the Corporate Social Responsibility movement. However, even though all of these are very interesting, important, and innovative methods of transnational governance that are trying to deal with some of the consequences of the fact that markets go beyond national governments, these structures are weak, and they’re likely to remain weak. On their own, they’re unlikely to support anything but a relatively limited version of globalization because the focus of democratic deliberation still resides largely with the nation state.

The third idea is that different nation states have different preferences over the shape that these institutions of governance ought to take. Because they differ in their historical trajectories, because of their cultural background, because of their levels of income and development, they have different preferences, and they have different needs. So, when we’re talking about the shape of a social protection mechanisms, or the shape that financial regulation ought to take, or the shape that labour-market institutions ought to take, or the form that consumer health and safety standards ought to take, there is going to be much variation across different parts of the world in terms of what is a locally desired form for these institutions. This diversity is natural. There is nothing in either theory or practice that suggests that capitalism, or a market-based system more generally, maps into a unique form of governance, into a unique set of regulations that ought to be globally harmonized, or that, necessarily, different countries will have similar preferences for the shape that these different regulatory institutions ought to take.

A patchwork

When you put these three ideas together, you end up with the conclusion that we have to contend with a world economy that is, and is likely to remain, a patchwork in terms of governance. We need to internalize the idea that the world economy is always going to be divided into different polities, and that jurisdictional boundaries will be there. This conclusion really puts a damper on how far we can go in terms of envisaging a truly global market, in terms of how far we can strive for what I call ‘hyper-globalization’, which refers to this ideal of a world economy where national borders don’t matter in the sense that they don’t impose any transaction costs on economic exchange.

When we get the balance between the reach of the market, and the reach of the ‘workable’ regulation wrong, then we tend to run into one of two kinds of problems:

1. We run into problems of legitimacy when we try to push the global rules too far, and try to harmonize institutional arrangements beyond what domestic political considerations would allow. I think the best example of this is the difficulty in which the current world trade regime finds itself. In fact, the WTO is one of the least popular institutions in the world. To a large extent, the reason for this is that we have overreached in terms of rule-making in the world trade regime.
2. On the other hand, when we don’t have these rules, when the global governance regime remains weak, or when the rules are highly country specific, then we get into problems of inefficiency and instability, and that has been the curse of financial globalization. I think that our experience with financial crises and problems of contagion and financial volatility globally, reflect, in part, the fact that we have a world in which financial markets are increasingly global, while the regulatory arrangements and the stabilizing arrangements are still based within nation states. We don’t have anything like a global regulator, or a global lender of last resort, or global fiscal policies.

The nation state

Coming full circle, my argument is not just that we have to rein in our ambitions because of the continuing power of the nation state, but also that it’s not necessarily a bad thing if we recognize the centrality of nation states in the world economy. We’re more likely to contribute to a healthy global economy when we recognize the validity of the constraints than when we try to eviscerate them. Weakening domestic governance arrangements ultimately benefits no one.

Whether or not you buy my argument about the inherent desirability of a world economy that’s divided across different national polities, we’re likely to move into a world where the balance of political forces is becoming significantly more centrifugal. This is, in part, because of the declining role of the United States in the global economy, and also because the European Union will likely remain highly preoccupied with its own financial crisis and its own unification process.

Rising powers

As for the rising powers, led of course by China, but also others like Brazil, India, Turkey, South Africa and Russia – even though they differ on a lot of different dimensions – there is one thing that is common to all of them, which is that all these rising powers tend to put a huge weight on the value of national sovereignty. So, these new powers are going to be standing for a world where in fact the nation state does matter, and there’s going to be much less willingness to transfer sovereignty to transnational or global governance mechanisms. The supply of global leadership is likely to be in short supply in any case.

Now, this might be a very pessimistic prospect if you think that, in order to maintain a healthy world economy, we require a lot of global cooperation, a lot of global governance, and a lot of global rule-making. It might suggest that we’re looking toward a somewhat bleak future. But I don’t think that’s that right way to look at it, because to maintain a healthy global economy, you basically need to ensure that countries do whatever is good for themselves. They need to look out for their own interests, not those of the global economy. This is a point that is not very well understood.

Semi-private goods

We often think of the global economy using the analogy of a global commons – we think that the world economy is like a global ecosystem. This is the wrong way to think about trade and financial policies, in the sense that trade and finance policies are what we would call ‘semi-private goods’ from the perspective of each individual nation. When we economists teach the benefits of trade, and the virtue of comparative advantage, we teach it from the perspective that this is good for each country in and of itself. We don’t teach that trade is good because this is how you provide benefits for the rest of the world. We say instead that trade is good because it enables you to allocate your own resources more efficiently. This is very different from a true global commons, for example, in the area of climate change, where in a world where each nation is doing whatever is good just for themselves, we would collectively all go to hell because nobody would have any incentive to invest in climate control. Trade and financial policies aren’t like that, because these are semi-private goods, and if countries adopt policies that are good for themselves, they will have open economic policies.

So, fundamentally, subject to a couple of caveats, an open economy is in fact in each individual country’s own interest. There are spillovers of course. There are spillovers in terms-of-trade effects, and potentially mercantilist effects, and this is why I call open trade and financial policy, semi-private goods, not purely private goods from the standpoint of individual countries. When a country, let’s say, follows protectionist policies, and if it is true that it is following these in order to ‘protect’ itself for economically inappropriate reasons, most of the bulk of the costs are actually borne not by the rest of the world, but by particular groups within that country.

The corollary of that is that when nation states in fact do have the manoeuvring room to select their own trade and financial policies and their own institutional arrangements that might potentially impose transaction costs on cross-border trade and financial relationships, the outcome need not be the slippery slope to protectionism.

Agricultural subsidies

I’m not making a claim that democratic politics are always going to result in the kind of economics with desirable outcomes, but the point is that when democratic politics do malfunction, the costs in the world economy are paid mostly by the locals, and not by the rest of the world. Of course, agricultural subsidies are a great example of that, because we say “here is a fundamental failure of the world economy or world governance arrangements” with respect to trade rules, and that countries like the United States, or those in Europe, or Japan, or Korea, with high rates of subsidies or agricultural protection, generate adverse consequences for countries that are agricultural exporters. But, of course, the fundamental economic logic of this is that when countries are subsidizing their agricultural products, if anything they’re providing a benefit to the rest of the world, because of the terms-of-trade gains that the rest of the world derives. But even leaving that aside, the answer to the question, “Who pays the cost of those policies?” is that the costs are paid for by domestic consumers and domestic tax payers. So, the ultimate failure here is not failure of global rules per se. It’s a failure of domestic deliberation, of domestic democracy. These are very costly policies from the standpoint of each individual country, and if a democracy ends up saying that despite those costs, we want these policies nonetheless, it is not because they want to impose costs on others, it’s because democracies are entitled to make their own mistakes.

Bigger gains

The point is that since the costs of ‘bad’ trade and financial policies are borne mostly at home, improved deliberation (and improved mechanisms of decision-making in these areas) is likely to be a much more powerful discipline, a much more powerful stick, than external constraints. After all, the bulk of the costs fall not abroad, but at home. And in any case, the mechanisms of governance within which we can sensibly address these issues are mostly national to begin with. So, this way of thinking about where we’re going has implications for how we think about the design of global institutions, how we think about where we should focus our energies. In other words, where are the bigger gains for international cooperation and rule-making?

One of the policy areas where one can apply some of these broader principles is with respect to what, in some sense, is the burning macroeconomic issue of the day which is, how do you deal with global macroeconomic imbalances?

China

Now this is an area where cross-border spillovers are large because you can argue, quite reasonably, that China’s mercantilist policies have costs for others. What I mean by China’s mercantilist policies is its currency and other policies that create a large trade surplus. These have costs elsewhere in the world economy, because they aggravate unemployment in the United States and elsewhere, and also have costs for economic growth in developing and emerging market economies because of the relationship between exchange-rates and economic growth. However, I think that what this debate has not taken on board sufficiently is that China also has valid concerns about the potential employment and social consequences of a rapid currency appreciation. So, for the last ten years, China’s growth model has relied extensively on an undervalued currency, and what one might call exchange-rate protection, which has increasingly replaced the kind of trade and industrial policies that China used to rely on, prior to joining the WTO in 2001. In fact, it’s quite striking that both the external imbalance and the exchange-rate undervaluation started to rise in 2001, just as China joined the WTO.

So, I think that one way of squaring the circle is to accept that if the rest of the world – the United States in particular – is going to come down hard on China to do something on the exchange rate front, it’s also incumbent on us to think whether China needs any insurance policy against the potential downside of loss of employment and significant reduction in economic growth that could be socially costly. And the kind of insurance policy that economic logic suggests we ought to provide China with is much greater freedom to employ sectoral policies in case particular sectors, or particular sets of firms, are adversely affected by a rapid appreciation of the Renminbi, potentially causing unemployment problems. The suggestion here is that greater discipline on macroeconomic and exchange-rate policies imposed on China is really viable only if is matched by significantly relaxed discipline on sectoral, or microeconomic, or industrial policies. In a way, the quid-pro-quo here is to look the other way if China is going to violate the agreement on subsidies of the WTO, and use sectoral policies in order to potentially pre-empt the employment costs of a rapid appreciation of the Renminbi. In exchange, the rest of the world can ask for greater global discipline over macroeconomic and currency policies.

Labour mobility

The second area is one area where globalization has advanced way too little. In international trade and international finance, we need to ask how we can mitigate the consequences of globalization having gone too far. But with respect to the world labour regime, we’re in a world where globalization has not gone far enough. The world labour regime today is roughly where the trade regime stood in the 1950s. We live in a world in which there are very high barriers to labour mobility, very inconsistent policies – quantitative restrictions all over. Now, what this means economically is that because we’re starting from a position where the size of barriers is so large, the relative balance between the total global efficiency gains and potentially adverse distributional effects of relaxing those barriers is highly skewed on the positive side. It is skewed in the direction of the net efficiency gains. For any dollar of redistribution we get from relaxing these temporary worker mobility barriers, the surplus we generate for the world economy, the extent by which we would increase the global pie, is much greater than from almost any other area of reform. Even a relatively small increase in the temporary work visa allocations of rich countries would produce net gains that are several times those produced by the removal of trade barriers, or anything else that’s currently under discussion regarding the world trade regime.

This is really the unexplored frontier of globalization, and I suggest that if the trade negotiators, who are wasting their time with Doha, really want to do something useful, and really expand the size of the global pie, this – and not the existing agenda – would be the area that they should be targeting.

Global rules

With respect to the nature of the global rules, I suggest that the main contribution that global rules can make is through their effect on improving the quality of domestic deliberation. If there is a shift in emphasis in places like the WTO or the G20, instead of trying to enact global rules that try to harmonize on substance in pursuit of the objective of minimizing transaction costs across borders, these global rules should instead focus on procedural safeguards that ensure that the domestic deliberation on regulatory matters affecting trade and finance benefit from some key qualitative improvements. The key principle here would be to ensure things like transparency, accountability, representativeness, and the use of scientific or economic evidence in domestic deliberations with respect to trade and industrial and financial policies. And international rules could set procedural standards, require the application of these principles, and, through such a mechanism, could actually make a contribution to the quality of domestic deliberation. The idea here is that there is much to be gained by legitimizing national differences and regulatory structures, but doing that subject to procedural safeguards that can potentially improve the quality of such deliberation.

To sum up, I believe that democratic deliberation is still largely organized around nation states, and I believe in the right of countries to protect their own regulatory arrangements and institutions, but I distinguish this very sharply from the right to impose those arrangements on others. The right to have your own institutions doesn’t give you a right to impose them on others. I think we should strive for as much economic globalization as we can get that is consistent with maintaining this space for diversity in domestic international arrangements.

Policy space

My emphasis here on creating policy space is based on the argument that all kinds of countries need that policy space; the rich nations need it to provide social safety nets and social insurance programmes, to address concerns about the labour, environmental or health and safety consequences of trade, and ultimately to shorten the chain of delegation whereby decisions are made by a group of judges in Geneva. And I think developing countries need the policy space, because the record shows us that it’s those countries that use the policy space to restructure their economies, and to diversify their economies, that ultimately benefit from globalization the most, and can leverage globalization the most.

Providing countries of both the North and the South – both rich and poor countries – with this kind of policy space, and understanding that this policy space is needed to maintain the integrity of domestic institutions, is something that is not just desirable from the narrow perspective of national economic management. It will actually produce a global economy that is workable and that is healthier.

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● Dani Rodrik is the Rafiq Hariri Professor of International Political Economy at the John F. Kennedy School of Government, Harvard University, USA. He has published widely in the areas of international economics, economic development and political economy. His research focuses on what constitutes good economic policy, and why some governments are better than others in adopting it. His latest book is The Globalization Paradox: Democracy and the Future of the World Economy. He was born and grew up in Istanbul, Turkey.

● This is an edited version of a talk given at the Peterson Institute for International Economics, Washington, DC, on 4 May 2011.