On International Political Economy Equilibria – Introductory thoughts, Constraints and some Intuition

Analysts, particularly economists, like to think of the world as a system moving towards and around “stable equilibria”. While this is not necessarily always true and a lot of systems do behave as a random walk, the relative usefulness of equilibrum should not be understated. Certainly, in long term economic growth theory, equilibria are not only useful, they are known and undeniable.

Below I attempt to sketch a rough draft of what a complete theory of equilibrium polities might look like from the perspective of International Political Economy.

In this post, I don’t claim to provide any new insight into these well-established theories. The insights of Mundell and Flemming’s model of international economics and the trilemma arising from it due to international interest rate parity are not particularly new. Neither are those conclusions arising from Rodriks’ augmented trilemma. My interest is their overlap and, more importantly, the conclusions that may be derived from the presumption a political economy equilibrium is sustainable, if and only if, it is both a political as well as an economic equilibrium. Below I offer some thoughts ahead of further wanderings.

Mundell-Flemming & Rodrik: Some Abstract Thoughts

The limited contribution I make is to take the economic and the political trilemmas (as described by Rodrik)…

… and overlap them in such a way as to show how their integration (in the specific context of European political economy)…

… allows us to conclude that only the 3 overlapping equilibria (out of all 9 possible political economy combinations, provide stable equilibria.

Constraints

When he described his trilemma of international political economy, Rodrik compared it with the economics trilemma arising from the open economy model of Mundell-Flemming’s fame. Although some overlap of the two models might have been implicit to his discussion, he never stated it explicitly. In stating it explicitly here, I am describing an equivalence between international economic and political institutions that depends on:

  • The level of international integration, as measured by the size of the capital and of the current account as a percentage of GDP, and whether fiscal or monetary policy dominates.
  • The level of inflation prevailing in the economy.
  • The amount of debt in the economy.
  • The level of economic growth.
  • The level of income inequality prevailing in the economy.

Intuition

My understanding of the overlap described above , and of the three specific equilibria available, is as such:

  • In the presence of capital mobility, if the exchange rate is flexible and the conservative monetary policy maker targets inflation, any non inflationary fiscal expansion will be opposed by the central bank who will raise interest rates to stem inflation. With monetary policy generally a national issue,  overlaping Rodrik’s concept of national politics with the economic concept of an independent monetary policy maker, because the central bank  is generally bound nationally. According to international economics, an open economy operating a flexible exchange rate policy is one where fiscal policy is powerless, which must inevitably mean that participatory democracy and political competition are meaningless or inexistent, because they must and inflation neutral. However, the foreign exchange arrangement and the independence of the central bank are not the only limitations forced upon fiscal policy. Indeed, in this international  to
  • According to international economics, an open economy whose currency’s exchange rate is fixed, monetary policy can no longer be used to smooth the inflationary effect of exogenous shocks because it becomes subservient to the forex peg. Instead fiscal policy is the only available lever. Fiscal policy is the tool of politicians, who collect here to redistribute there. Therefore, fixed exchange rates, the system where fiscal policy dominates, has a political equivalence in Rodrik’s idea of mass, competitive and participatory democratic politics where different parties offer clear alternatives to one another. However, according to the literature on the race to the bottom, as summarised by Font, Doucouliagos and Albuquerque (2011) and as theorised most recently  by Hauptmeier, Mittermaier and Rincke (2009), international openess implies  fiscal competition for mobile resources (capital) which causes states to lower corporate and financial taxes and decrease non salient social expenditure. Thus international capital mobility inevitably leads to fiscal competition and a limited scope of policy intervention, the only solution to which is the introduction of a higher level of government that is able to encompass all competing polities and negative economic externalities, in order to mitigate the constraints imposed on political competition.
  • However, if international capital mobility is credibly hindered, then domestic and foreign speculators become unable to arbitrate between domestic and foreign markets. In so doing, the value of domestic resources is constrained to the value of the goods already present and to internal lenders’ ability to multiply these assets through loans. Because the latter is determined by the central bank’s accepted collateral rules and official rate, independent monetary policy becomes possible. Moreover, it is evident that in closed economies, the gatekeepers are able to control and potentially fix the value of the domestic currency to any international, domestic or commodity benchmark, by limiting the inflow of foreign resources. This means that the government is not pressured by international arbitration, freeing it from fiscal and regulatory competition. In the absence of these forces, there is no race to the bottom to limit the scope of political competition driving fiscal policy and the only constraint of the government is to pursue fiscal policies that are inflation neutral. Thus, limitations to capital mobility allow for a system of fixed exchange rates where politicians are able to compete on a wider field of fiscal policies, in parallel to an independent monetary policy maker who manages OMOs independently of exchange rates. Not withstanding the fact that the limitation of international capital flows (trade or financial) is not akin to autarky, the Nationalist/Bretton Woods system imposes a growth premium to economies who chose it, to the extent that it provides for slower arbitrage and thus a less efficient economic system.

In light of these equivalences, it should be immediate that any political economy system that does not reflect this dual political and economic equilibrium, is not sustainable.

  • If an economy is open, and monetary policy is independent (in the sense that it is not bound by foreign exchange movements), then fixed exchange rates are not feasible, meaning that fiscal policy will be counteracted by monetary policy. The result will be a narrower space of political competition as states must compete against one another for the increasingly mobile resources that fuel such an economy, as described by Friedman and most recently theorised by Hauptmeier, Mittermaier and Rincke (2009).
  • On the other hand, if exchange rates are fixed, then monetary policy can no longer respond adequately to either exogenous (asymmetric) shocks or endogenous fiscal shocks. A supranational government established between the political economies with pegged currencies will be able to take from the non affected country and give it to the affected one, thus creating a localised stimulus that is debt neutral as it takes from the side that is growing to the side that is slowing. However, if politics remain national, then the fiscal stimulus would not be debt neutral. It would create a rising deficit which if not financed domestically would lead to rising funding costs. This would eventually  put the sovereign on an unsustainable fiscal path that would see the cost of debt rising due to rising risk premia. This would erode the liquidity market (LM), leading to repeated shocks to the monetary base, which would contract aggregate demand in an endogenous shock caused by this fiscal bubble. Sounds familiar?
  • Finally, if the debt is financed domestically, it is much less likely to lead to unsustainable conditions as holders will internalise the government’s progressive inability to finance rising funding costs.

These are just some preliminary thoughts, which I intend to elaborate on and illustrate not just in the context of the ongoing Euro-Zone sovereign debt crisis, but also in the context of as many desiquilibria as possible. So stay tuned for more…

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