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THE WEAK CASE FOR GLOBAL ECONOMIC GOVERNANCE

Dani Rodrik1 Institute for Advanced Study

September 2014

The argument for global economic governance is weaker than is usually thought, for two

sets of reasons. First, most of the failures global rules aim to fix are domestic in nature and

cannot be properly addressed internationally. Second, the autonomy of nation states retains

significant normative value. These notes elaborate on these counter-‐arguments.

Thinking about global governance: first principles

Global problems, it is said, require global solutions. So the search is on for global

governance, with policy makers as well as academics proffering visions of new forms of

governance that leave the nation state behind. Few of these advocates envisage a truly global

version of the nation state; a global legislature or council of ministers is too much of a fantasy.

The solutions on offer rely instead on new conceptions of political community, representation,

and accountability. The hope is that these innovations can replicate many of constitutional

democracy’s essential functions at the global level.

The crudest forms of such global governance envisage straightforward delegation of

national powers to international technocrats. Perhaps for obvious reasons, economists are

particularly enamored of such arrangements. For example, when the European economics

1 This text is prepared as background reading for a presentation at the Princeton International Relations Colloquium, and draws heavily from several of my recent writing: The Globalization Paradox, Norton, 2011, chap. 10; After the Fall: The Future of Global Cooperation (written jointly with Jeff Frieden, Michael Pettis, and Ernesto Zedillo), July 2012; and Who Needs the Nation State? (Roepke Lecture), Economic Geography, 89(1), January 2013.

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network VoxEU.org solicited advice from leading economists on how address the frailties of the

global financial system in the wake of the 2008 crisis, the proposed solutions often took the

form of tighter international rules administered by some kind of technocracy: an international

bankruptcy court, a world financial organization, an international bank charter, or an

international lender of last resort, and so on.2

Others, such as Anne-‐Marie Slaughter, have focused on transnational networks created

by regulators, judges, and even legislators. These networks can perform governance functions

even when they are not constituted as inter-‐governmental organizations or formally

institutionalized. Such networks, Slaughter argues, extend the reach of formal governance

mechanisms, allow persuasion and information sharing across national borders, contribute to

the formation of global norms, and can generate the capacity to implement international norms

and agreements in nations where the domestic capacity to do so is weak.3

John Ruggie has emphasized the parallel role that global civil society can play, by

enunciating global norms of corporate social responsibility in human rights, labor practices,

health, anti-‐corruption, and environmental stewardship. The United Nation’s Global Compact,

which Ruggie had a big hand in shaping, embodies this agenda. The Compact aims to transform

international corporations into vehicles for the advancement of social and economic goals. The

goal is to allow the private sector to shoulder some of the functions that states are finding

2 See http://voxeu.org/index.php?q=node/2544. 3 Anne-‐Marie Slaughter, A New World Order, Princeton University Press, Princeton and Oxford, 2004.

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increasingly difficult to finance and carry out, as in public health and environmental protection,

narrowing the governance gap between international markets and national governments.4

Joshua Cohen and Charles Sabel have gone even further in outlining a future in which

accountability takes a truly global form. They envisage global deliberative processes among

regulators which feed into the development of a global political community, with people

coming to share a common identity as members of an “organized global populace.”5 At the end

of the day, true global governance requires individuals who feel that they are global citizens.

The nation state does not have many defenders. As Sen puts it, “there is something of a

tyranny of ideas in seeing the political divisions of states (primarily, national states) as being, in

some way, fundamental, and in seeing them not only as practical constraints to be addressed,

but as divisions of basic significance in ethics and political philosophy.”6 At the same time few

would deny that political authority still remains vested for the most part in national

governments. The global government arrangements described above require the transfer of

substantial authority, and indeed sovereignty, from national institutions to transnational, multi-‐

national, or multilateral entities. This is difficult because national sovereignty is zealously

guarded, not least by domestic politicians who do not want to see their prerogatives eroded.

The challenge is not going to get easier in the years ahead. The rising powers of the world

economy -‐-‐ China, India, Brazil and other emerging market economies -‐-‐place if anything

greater importance on national sovereignty than the traditional great powers.

4 John G. Ruggie, Reconstituting the Global Public Domain -‐-‐ Issues, Actors, and Practices,” European Journal of International Relations, vol. 10, 2004, pp. 499-‐531. 5 Cohen and Sabel, 2005, p. 796. 6 Amartya Sen, The Idea of Justice, Harvard University Press, Cambridge, MA, 2009, p. 143.

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But there is more to it than the self-‐interest of national politicians. Arguments on behalf

of new forms of global governance—whether of the delegation, network, or corporate social

responsibility type—raise troubling questions. To whom are these mechanisms supposed to be

accountable? From where do these global clubs of regulators, international non-‐governmental

organizations, or large firms get their mandates? Who empowers and polices them? What

ensures that the voice and interests of those who are less globally networked are also heard?

In a nation state, the electorate is the ultimate source of political mandates and elections the

ultimate vehicle for accountability. If you do not respond to your constituencies’ expectations

and aspirations, you are voted out. The democratic state is tried and tested. Its global

counterpart sounds too experimental and utopian.7

Discussions in the G20, World Trade Organization, and other multilateral fora often

proceed as if the correct remedy for our economic problems is always more global cooperation

– more rules, more harmonization, more discipline on national policies. In view of the practical

and substantive challenges that global governance faces, we need a more calibrated approach

that focuses on areas where the need for building global institutions is greatest, while not

wasting political or organizational capital in areas where the returns are small.

Going back to basics, the principle of “subsidiarity” provides the right way of thinking

about issues of global governance. It tells us which kinds of policies should be coordinated or

7 For example, it is interesting that Slaughter’s most telling illustrations of networked global governance come from the area of financial markets. She points to the International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision as networks of regulators that set global rules for financial markets. Most economists would say, however, that these institutions have failed to deliver an adequate set of rules. Many would also argue that they have been too dominated by financial industry interests and that the Basle Committee’s capital adequacy rules have in fact played a contributing role in both the Asian financial crisis of 1997-‐98 and the global financial crisis of 2008-‐2009.

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harmonized globally and which should be left largely to domestic decision-‐making. The

principle demarcates areas where we need extensive global governance and areas where only a

thin layer of global rules is adequate. To use a concrete illustration, we can think of this as a

choice between a WTO-‐type (thick) global regime versus GATT-‐type (thin) regime.

The premise in what follows is that any practical mechanism of global governance must

rely on the willingness of national governments to submit to international discipline. Nation

states, the primary decision-‐making units in the world economy, must be provided with a

reason as to why it is in their interest to cooperate and coordinate, rather than go at it alone.

Transnational altruism is not a reliable pillar on which to construct global governance.

To see how the principle of subsidiarity applies, I will make a distinction between four

different variants in which economic policies come. I start from the two extremes, “purely

domestic policies” and “global commons policies,” which are the easiest to describe and have

the most direct implications for global governance. Then I turn to the trickier intermediate

cases, which I call “beggar-‐thy-‐neighbor” and “beggar-‐thyself” policies.

(a) Purely domestic policies

At one extreme are domestic policies that create no (or very few) direct spillovers across

national borders. Examples are educational policies, highway safety standards, and urban

zoning. Since the object of regulation in both instances is a non-‐traded service (human capital,

local transportation, and real estate, respectively), such policies do not affect economic

interests of other countries, at least directly. They therefore require no international

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agreement and can be safely left to domestic policymakers. This seems to be widely accepted,

as there is little clamor for internationalization of regulation in such areas.

Of course, in practice regulations in non-‐traded markets influence the rest of the

economy and therefore have implications for other nations as well. Highway safety standards

for example can affect the demand for oil and its price on world markets. Nothing is purely

domestic when general equilibrium implications are taken into account. But it is understood or

presumed that such effects are indirect, uncertain, and that the intent of policies is not to

discriminate against foreign economic interests.

(b) Global commons policies

At the other end are policies that relate to “global commons,” such as global climate.

The characteristic of a global commons is that the outcome for each nation is determined not

by domestic policies per se, but by (the sum total of) all countries’ policies. The classic case is

greenhouse gas emissions. Global climate is a pure global public good, in that no country can

be excluded from benefiting from the control of greenhouse gases in other countries, nor can a

country keep the benefits of such policies to itself.

There is a very strong case for establishing global rules in these policy domains, since it

is in the interest of each country, left to its own devices, to neglect its share of the upkeep of

the global commons. Absent a binding agreement, the rational strategy for any small country is

to free ride on other countries’ emissions policies. Since each country reasons the same way,

the decentralized outcome is one where no country invests in costly climate control policies.

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Hence failure to reach global agreement would condemn all to a collective disaster.8 That is

why there is no alternative to global governance in the area of climate change, as difficult as it

may be to achieve.

True global public goods are rare. Even though the global economy is often portrayed in

a similar light, in fact few economic policies qualify as “global commons policies” in the sense

sketched out above. We commonly hear statements to the effect that “a growing, open world

economy is a global public good.” The idea seems to be that as each nation pursues its own

narrow interests, the world economy would slide into rampant protectionism and everyone

would lose as a result.

But this logic relies on a false analogy of the global economy as a global commons.

What makes global warming a global rather than national problem, requiring global

cooperation, is that the globe has a single climate system. It makes no difference where the

carbon is emitted. One might say that all our economies are similarly intertwined, and no

doubt that would be true to an important extent. But in the case of global warming, domestic

restrictions on carbon emissions provide no or little benefit at home. By contrast, good

economic policies –including openness -‐-‐ benefit the home economy first and foremost. The

economic fortunes of individual nations are determined largely by what happens at home

rather than abroad. If open economy policies are desirable it’s because openness is in a

nation’s own self-‐interest—not because it helps others. Openness and other good policies that

contribute to global economic stability rely on self-‐interest, not on global spirit.

8 Large countries have some incentive to control emissions, to the extent that their contribution to the global stock of greenhouse is non-‐trivial.

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Put differently, the desirability of free trade and appropriate financial regulations at the

national level is largely independent of policies in other countries. If other countries also follow

“good” policies, all the better for us. But differently from climate change, there is no logic that

suggests countries will systematically follow policies that are harmful to the world economy. In

fact, quite to the contrary.

However, there are two caveats. First, sometimes domestic economic advantage comes

at the expense of other nations. Second, there is no guarantee that countries will do what is

economically right for themselves, for reasons of domestic politics gone awry or sheer

ignorance. These exceptions give us two intermediate cases between purely domestic policies

and global commons, which we analyze under the headings of “beggar-‐thy-‐neighbor policies”

and “beggar-‐thyself policies.”

(c) Beggar-‐thy-‐neighbor policies

These are policies whereby a nation derives an economic benefit at the expense of

other nations. The purest illustration occurs when a dominant supplier of a natural resource,

such as oil, restricts supply on world markets so as to drive up world prices. In this instance the

exporter’s gain is the rest of the world’s loss. Plus there is an additional global deadweight loss

due to the supply restriction. A similar mechanism operates with the so-‐called “optimum

tariff," whereby a large country manipulates its terms of trade by placing tariffs on its imports.

There is a clear case in these instances for global coordination taking the form of limiting or

prohibiting the use of such policies.

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In some instances, beggar-‐thy-‐neighbor effects may be intermingled with other,

domestic motives. Consider for example currency undervaluation, which is often treated as a

mercantilist policy aimed at extracting economic advantage from other countries. China’s

motive in pursuing such a policy seems to have been primarily to accelerate its economic

growth by promoting structural change from low-‐ to high-‐productivity areas. To the extent that

this policy generates an external surplus, it requires that other nations be willing to bear the

counterpart deficits. But in what sense does this impart a harm on other countries? In the case

of China’s currency policies, for example, it was often asserted prior to the global financial crisis

that there was a willing partner in the United States. America’s trade deficit allowed it to

borrow and finance its consumption and credit boom on the cheap, while China subsidized its

exports through a cheap renminbi. There were some complaints in the U.S. from those

adversely affected by China’s exports. But these complaints were drowned by those who

argued the relationship was mutually beneficial, even if of doubtful sustainability.

Global imbalances have become a much more serious issue in the aftermath of the

financial crisis. This is partly because there is a sense that large current account surpluses such

as those of China have contributed to financial fragility in the past. It is also due to the spike in

unemployment in the U.S. and the adjustment difficulties in the Euro zone. When the economy

looks like it is caught in a situation of inadequate aggregate demand, external deficits

contribute to the problem and aggravate unemployment. Paul Krugman famously wrote in

2009 that “we’re looking at 1.4 million U.S. jobs lost due to Chinese mercantilism.”9 Whether

there is such a direct link or not, currency policies that export unemployment and financial

9 Krugman 2009, http://krugman.blogs.nytimes.com/2009/12/31/macroeconomic-‐effects-‐of-‐chinese-‐mercantilism/.

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instability increasingly look like beggar-‐thy-‐neighbor policies. They are an area where global

cooperation and coordination becomes necessary, at least among systemically large countries.

Rules with regard to bank secrecy or the taxation of capital present other instances

where there is a mix of considerations. A jurisdiction that is set up as a pure tax haven, with the

sole objective of attracting deposits and capital from abroad can be said to gain economic

advantage at the expense of other nations and to follow beggar-‐thy-‐neighbor policies. But

what if a nation views low taxes or strict secrecy as “correct” policies to follow for domestic

reasons, regardless of consequences for cross-‐border flows of money? Then, even if such

policies have adverse effects on others, the case for global coordination is significantly

weakened. Disciplining low-‐tax jurisdictions under such considerations would require an

account how a global economic loss is created in the absence of coordination.

Analytically, it helps to distinguish between the level of a policy that is domestically

optimal absent cross-‐border interactions and the increment in that policy that becomes

desirable once those interactions are taken into account. There should be a much higher

threshold for disciplining the first component. Take tariffs for example. Suppose t is the

domestically second-‐best level of taxation in an economy (due to, say, revenue reasons),

holding the external terms of trade constant. Assume that the optimal level of the tariff

becomes t’ = t + dt once external terms-‐of-‐trade effects are taken into account. The dt

component of the tariff is the pure beggar-‐thy-‐neighbor component, which ought to be

regulated internationally. There is much less ground for international discipline on t, unless

other countries can demonstrate significant negative spillovers which more than offset the

benefits to the home country.

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(d) Beggar-‐thyself policies

Beggar-‐thy-‐neighbor policies have to be distinguished from what we may call “beggar

thyself” policies. The latter are policies whose economic costs are borne primarily at home,

even though they may produce effects on others. Examples are agricultural subsidies, bans on

genetically modified organisms, or lax financial regulation. In each instance, there may be costs

to other countries. But these policies are deployed not to extract advantages from other

nations, but because other competing policy objectives at home – such as distributional,

administrative, or public-‐health concerns -‐-‐ dominate the economic motives.

Consider for example agricultural subsidies in Europe. Economists generally agree that

these are inefficient and that the benefits to European farmers come at large costs to everyone

else. Economists also agree that the bulk of those costs are paid by European residents, in the

form of high prices, high taxes, or both. The subsidies do produce spillovers to other nations.

Agricultural producers around the world get hurt, while consumers of agriculture benefit.

Even though the presence of such spillovers is often taken to establish a case for global

governance over these policies – as in the Doha Round of trade negotiations – it is not clear

why that should be so. There can be two reasons for the pursuit of beggar-‐thyself policies:

there can be compensating non-‐economic benefits, or the government in question can be

simply making a mistake. Consider each of these two possibilities in turn.

Say that European governments have decided the economic costs of agricultural

subsidies are worth paying for as the price for sustaining healthy rural farming communities.

Even though the policy is economically inefficient, in this case it serves a broader social purpose

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and therefore is optimal, from Europe’s own perspective. A direct implication is that any global

effort to reduce or eliminate these subsidies would leave Europe worse off. Even if such an

attempt were to produce net economic benefits to the rest of the world, it would come at the

expense of socio-‐economic losses for Europe. Thus there would seem to be a very weak case

for global discipline. After all, it should not be up to the “global community” to tell individual

nations how they ought to weight competing goals.

This doesn’t preclude a global conversation over the nature of diverse benefits and

harms to the parties. Such conversations can be helpful in reducing international

misunderstanding about the objective of policies, and sometime in establishing new behavioral

norms. They can also enable some Coasian bargains to be struck if the losses incurred by other

nations do exceed domestic benefits. But global restrains on domestic policy space on account

of the spillovers per se would seem inappropriate since there is no prima facie reason why the

economic interests of other nations ought to take precedence over the social-‐economic

benefits to the home nation. Once again, it is unclear whether the net benefit to the world from

global discipline is positive.

The case against global regulation becomes even stronger when the spillovers to the

rest of the world from the economically “harmful” policy are, on balance, positive. This may

seem unlikely, but note that it is indeed the case with export subsidies in agriculture. Economic

analysis suggests that such subsidies improve the terms of trade of the rest of the world and is

therefore a “gift” from a country to its trade partners. Some countries or groups are harmed,

of course. But it is difficult to see why this should be a reason for restraining home country

policies. Consider an analogous situation where a country decides, unilaterally, to reduce its

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import tariffs. Similar to the export subsidy case, some other nations – those who import

similar things -‐-‐ may well get hurt. Yet economists, reasonably, would never contemplate

enacting global rules that restrict a country’s ability to liberalize its trade!

Let’s now go to the second case where the country in question has actually made a

“mistake.” So presume that agricultural subsidies are an unambiguously bad idea, even when

all other potential non-‐economic benefits are taken into account. Yet somehow the country’s

political system has failed, and delivers a bad policy. Indeed, there is no guarantee that

domestic policies accurately reflect societal demands. Policy makers may be ignorant or

captured. Even democracies are frequently taken hostage by special interests.

In principle, both domestic and foreign welfare would be enhanced if one could design

global rules that prevent such mistaken policies from being adopted. The trouble is that similar

policy failures can take place at the international level as well. Most economists would agree

that banking interests and pharmaceutical companies have exerted too much influence in

setting Basle capital adequacy rules and WTO intellectual property rules, respectively.

Moreover, it is not easy to distinguish in practice domestic policy failures from non-‐economic

considerations. Technocratic governance at the global level may fail to reflect adequately the

kind of non-‐efficiency objectives that play a role in democracies, as in the agricultural subsidy

context for example. In other words, technocrats (trade lawyers, economists, financial

specialists) may substitute their own normative judgments for those of democratic polities.

As Keohane, Macedo and Moravcsik point out, there are various ways in which global

rules can enhance democracy -‐-‐ a process that they call “democracy enhancing

multilateralism.” Democracies have various mechanisms for restricting the autonomy or the

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policy space of decision makers. For example, democratically elected parliaments often

delegate power to independent or quasi-‐independent autonomous bodies. Central banks are

often independent and there are various other kinds of checks and balances in constitutional

democracies. Similarly, global rules can make it easier for national democracies to attain the

goals that they pursue even if they entail some restrictions in terms of autonomy. Keohane at

al. discuss three specific mechanisms: global rules can enhance democracy by offsetting

factions, protecting minority rights, or by enhancing the quality of democratic deliberation.

However, just because globalization can enhance democracy does not mean that it

always does so. In fact there are many ways in which global governance works in quite the

opposite way from that described by Keohane et al. Anti-‐dumping rules, for example, augment

protectionist interests. Rules on intellectual property rights and copyrights have privileged

pharmaceuticals companies and Disney Company against the general interest. Similarly, there

are many ways in which globalization actually harms rather than enhances the quality of

democratic deliberation. For example, preferential or multilateral trade agreements are often

simply voted up or down in national parliaments with little discussion, simply because they are

international agreements. Globalization-‐enhancing global rules and democracy-‐enhancing

global rules may have some overlap; but they are not one and the same thing.

So it is problematic as a general rule to try to fix domestic policy failures by setting

global rules that define what acceptable policies are. But we can envisage another type of

global discipline which acts directly on the relevant margin. I have in mind procedural

requirements designed to enhance the quality of domestic policy making. Global disciplines

pertaining to transparency, broad representation, accountability, and use of

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scientific/economic evidence in domestic proceedings – without constraining the end result –

are examples of such requirements.

Disciplines of this type are already in use in the WTO to some extent. The Agreements

on Safeguards and Anti-‐Dumping specify domestic procedures that need to be followed when a

government contemplates restricting imports from trade partners. Similarly the SPS Agreement

explicitly requires the use of scientific evidence when health concerns are at issue. Procedural

rules of this kind can be used much more extensively and to greater effect to enhance the

quality of domestic decision-‐making. For example, anti-‐dumping rules can be improved by

requiring that consumer and producer interests that would be adversely affected by the

imposition of import duties take part in domestic proceedings. Subsidy rules can be improved

by requiring economic cost-‐benefit analyses.

Summing up on global governance

To summarize, different types of policies call for different responses at the global level.

The conceptual framework laid out here suggests the following typology of optimal global

regimes:

A. Purely domestic policies require no global action.

B. Global commons require globally harmonized policy regimes. (Example: a global

set of rules that allocate emission permits.)

C. Beggar-‐thy-‐neighbor policies require the regulation of cross-‐border spillovers.

(Examples: tariff bindings and restrictions on maximum size of current account

deficits/surpluses.)

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D. Beggar-‐thyself policies require global regimes aimed at enhancing quality of

domestic decision-‐making. (Examples: rules pertaining to transparency,

representativeness, accountability, and use of scientific/economic evidence in domestic

proceedings.)

Different types of policies call for different responses at the global level. At present, too

much global political capital is wasted on harmonizing beggar-‐thyself policies (particularly in the

areas of trade and financial regulation), and not enough on beggar-‐thy-‐neighbor policies (such

as macroeconomic imbalances). Over-‐ambitious and misdirected efforts at global governance

will not serve us well at a time when global cooperation is bound to remain in limited supply.

The principles above leave plenty of room for international cooperation over economic

matters. But they do presume a major difference, when compared to other areas like climate

change, in the degree of international cooperation and coordination needed to make the global

system work. In the case of global warming self-‐interest pushes nations to ignore the risks of

climate change, with an occasional spur towards environmentally responsible policies when a

country is too large to overlook its own impact on the accumulation of greenhouse gases. In

the global economy self-‐interest pushes nations towards openness, with an occasional

temptation towards beggar-‐thy-‐neighbor policies when a large country possesses market

power.10 A healthy global regime has to rely on international cooperation in the former case; it

has to rely on good policies geared towards the domestic economy in the latter.

10 In the language of economics, the global climate is a “pure” public good whereas an open economy is a private good, from the standpoint of individual nations, with some external effects on others.

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Let me go one step further. I would claim that virtually none of our global economic

problems today arise from the absence of international discipline per se. Global poverty and

low growth, financial instability and crises, trade protectionism – these are all failures that

derive from the pursuit of policies that harm the home economy first and foremost. Global

rules that are meant to prevent doing damage to others’ economies can make at best little

contribution to fixing these failures. And they can do real harm when they preclude the

achievement of legitimate domestic goals.

A normative case for the nation state

Historically, the nation state has been closely associated with economic, social, and

political progress. It curbed internecine violence, expanded networks of solidarity beyond local

communities, spurred mass markets and industrialization, enabled the mobilization of human

and financial resources, and fostered the spread of representative political institutions (Tilly

1992, Gellner 1983, Pinker 2011, Kedourie 1993 [1960], Anderson 2006). Civil wars and

economic decline are the usual fate of today’s “failed states.” For residents of stable and

prosperous countries, it is easy to overlook the role that the construction of the nation state

played in overcoming such challenges. The nation state’s fall from intellectual grace is in part a

consequence of its achievements.

But has the nation state, as a territorially confined political entity, truly become a

hindrance to the achievement of desirable economic and social outcomes in view of the

globalization revolution? Or does the nation state remain indispensable to the achievement of

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those goals? In other words, is it possible to construct a more principled defense of the nation-‐

state, one that goes beyond stating that it exists and that it hasn’t withered away?

Let me clarify my terminology. The nation state evokes connotations of nationalism.

The emphasis in my discussion is not on the “nation” or “nationalism” part but on the “state”

part. In particular, I am interested in the state as a spatially demarcated jurisdictional entity.

From this perspective, I view the nation as a consequence of a state, rather than the other way

around. As Abbé Sieyès, one of the theorists of the French revolution, put it: “What is a nation?

A body of associates living under one common law and represented by the same legislature”

(quoted in Kedourie 1993, 7). I am not concerned with debates over what a nation is, whether

each nation should have its own state, or how many states there ought to be.

Instead, I wish to develop a substantive argument for why robust nation states are

actually beneficial, especially to the world economy. I want to show that the multiplicity of

nation states adds rather than subtracts value.

My starting point is that markets require rules, and that global markets would require

global rules. A truly borderless global economy, one in which economic activity is fully

unmoored from its national base, would necessitate transnational rule-‐making institutions that

match the global scale and scope of markets. But this would not be desirable, even if it were

feasible. Market-‐supporting rules are non-‐unique. Experimentation and competition among

diverse institutional arrangements therefore remain desirable. Moreover, communities differ in

their needs and preferences with regard to institutional forms. And geography continues to

limit the convergence in these needs and preferences.

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Consider how financial markets should be regulated. There are many choices to be

made. Should commercial banking be separated from investment banking? Should there be a

limit on size of banks? Should there be deposit insurance, and if so, what should it cover?

Should banks be allowed to trade on their own account? How much information should they

reveal about their trades? Should executives’ compensation be set by directors, with no

regulatory controls? What should the capital and liquidity requirements be? Should all

derivative contracts be traded on exchanges? What should be the role of credit-‐rating

agencies? And so on.

A central trade-‐off here is between financial innovation and financial stability. A light

approach to regulation will maximize the scope for financial innovation (the development of

new financial products), but at the cost of increasing the likelihood of financial crises and

crashes. Strong regulation will reduce the incidence and costs of crises, but potentially at the

cost of raising the cost of finance and excluding many from its benefits. There is no single

optimal point along this trade-‐off. Requiring that communities whose preferences over the

innovation-‐stability continuum vary all settle on the same solution might have the virtue that it

reduces transaction costs in finance. But it would come at the cost of imposing arrangements

that are out of sync with local preferences. That is in fact the conundrum that financial

regulation faces at the moment, with banks pushing for common global rules and domestic

legislatures and policy makers resisting.

Here is another example from food regulation. In a controversial 1998 case, the World

Trade Organization sided with the United States in ruling that the European Union ban on beef

reared on certain growth hormones violated the Agreement on Sanitary and Phytosanitary

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Standards. It is interesting that the ban did not discriminate against imports and applied to

imported and domestic beef alike. There did not seem to be a protectionist motive behind the

ban, which had been pushed by consumer lobbies in Europe alarmed by the potential health

threats. Nonetheless the WTO judged that the ban violated the requirement in the SPS

Agreement that policies be based on “scientific evidence.” (In a similar case in 2006, the WTO

also ruled against EU restrictions on genetically modified food and seeds (GMOs), finding fault

once again with the adequacy of EU scientific risk assessment.)

There is indeed scant evidence to date that growth hormones pose any health threats.

The EU argued that it had applied a broader principle not explicitly covered by the WTO, the

“precautionary principle,” which permits greater caution in the presence of scientific

uncertainty. The precautionary principle reverses the burden of proof. Instead of asking “is

there reasonable evidence that growth hormones or GMOs have adverse effects?” it requires

policy makers to ask “are we reasonably sure that they do not?” In many unsettled areas of

scientific knowledge, the answer to both questions can be “no.” Whether the precautionary

principle makes sense depends both on the degree of risk aversion and on the extent to which

potential adverse effects are large and irreversible.

As the European Commission argued (unsuccessfully), regulatory decisions here cannot

be made purely on the basis of science. Politics, which aggregates a society’s risk preferences,

must play the determinative role. It is not unreasonable to expect that the outcome will vary

across societies. Some (like the U.S.) will go for low prices, others (like the EU) for greater

safety.

-‐21-‐

The suitability of institutional arrangements also depends on levels of development and

historical trajectory. Alexander Gerschenkron (1962) famously argued that lagging countries

would need institutions – such as large banks and state directed investments – that differed

from those present in the original industrializers. To a large extent, his arguments have been

validated. But even among rapidly growing developing nations, there is considerable

institutional variation. What works in one place rarely does in another.

Consider how some of the most successful developing nations joined the world

economy. South Korea and Taiwan relied heavily on export subsidies to push their firms

outward during the 1960s and 1970s, and liberalized their import regime only gradually. China

established special economic zones (SEZs) in which export-‐oriented firms were allowed to

operate under different rules than those applied to state enterprises and to others focused on

the internal market. Chile, by contrast, followed the textbook model and sharply reduced

import barriers in order to force domestic firms to compete with foreign firms directly in the

home market. The Chilean strategy would have been a disaster if applied in China, as it would

have led to millions of job losses in state enterprises and incalculable social consequences. And

the Chinese model would not have worked as well in Chile, a small nation that is not an obvious

destination for multinational enterprises.

Alberto Alesina and Enrico Spolaore (2003) have explored how heterogeneity in

preferences interacts with the benefits of scale to determine endogenously the number and

size of nations. In their basic model, individuals differ in their preferences over the public

goods – which we might also think of specific institutional arrangements – provided by the

state. The larger the population over which the public good is provided, the lower the unit cost

-‐22-‐

of provision. On the other hand, the larger the population, the greater the number of people

who find their preferences ill-‐served by the specific public good provided. Smaller countries are

better able to respond to their citizens’ needs. The optimum number of jurisdictions, or nation

states, trades off the scale benefits of size against the heterogeneity costs of public good

provision.

The important analytical insight of the Alesina-‐Spolaore model is that it makes little

sense to optimize along the market size dimension (and eliminate jurisdictional discontinuities)

when there exist heterogeneity in preferences along the institutional dimension. The

framework does not tell us whether we have too many nations at present, or too few. But it

does suggest that a divided world polity is the price we pay for institutional arrangements that

are, in principle at least, better tailored to local preferences and needs.

So I accept that nation states are a source of disintegration for the global economy. My

claim is that an attempt to transcend them would be counterproductive. It would get us neither

a healthier world economy, nor better rules.

My argument can be presented as a counterpoint to the typical globalist narrative,

depicted graphically in the top half of Figure 1. In this narrative, economic globalization,

spurred by the revolutions in transport and communication technologies, breaks down the

social and cultural barriers among people in different parts of the world, and fosters a global

community. This in turn enables the construction of a global political community – i.e., global

governance – which underpins and further reinforces economic integration.

My alternative narrative (shown at the bottom of Figure 1) emphasizes a different

dynamic, one that sustains a world that is politically divided and economically less than fully

-‐23-‐

globalized. In this dynamic, preference heterogeneity and institutional non-‐uniqueness, along

with geography, create a need for institutional diversity. Institutional diversity blocks full

economic globalization. Incomplete economic integration in turn reinforces heterogeneity and

the role of distance. When the forces of this second dynamic are sufficiently, strong, as I will

argue they are, operating by the rules of the first can get us only into trouble.

Concluding remarks

The design of institutions is shaped by a fundamental trade-‐off. On the one hand,

relationships and heterogeneity push governance down. On the other, the scale and scope

benefits of market integration push governance up. A corner solution is rarely optimal. An

intermediate outcome, a world divided into diverse polities, is the best that we can do.

Our failure to internalize the lessons of this simple point leads us to pursue dead ends.

We push markets beyond what their governance can support. We set global rules that defy the

underlying diversity in needs and preferences. We eviscerate the nation state without

compensating improvements in governance elsewhere. The failure lies at the heart of

globalization’s unaddressed ills as well as the decline in our democracies’ health.

-‐24-‐

Figure 1. The dynamics supporting the globalist and nation-state equilibria.

Rodrik-IR Fac Col Paper - Princeton...

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