From Great Depression to Great Recession

Chapter 5. Capital Flows and International Order: Trilemmas and Trade-Offs from Macroeconomics to Political Economy and International Relations

Atish Ghosh, and Mahvash Qureshi
Published Date:
March 2017
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Michael Bordo and Harold James 

Globalization—the establishment of cross-national linkages—is rarely a simple, unidirectional process. It creates major strains as different economic, social, and political systems adapt to each other’s influences. This chapter describes the challenges of globalization in terms of the logic underpinning four distinct policy constraints or “trilemmas” and their interrelationship, in particular, the disturbances that arise from capital flows. The analysis of a policy trilemma was first developed as a diagnosis of exchange rate problems (the incompatibility of free capital flows with monetary policy autonomy and a fixed exchange rate regime), but the approach can be usefully extended. The second trilemma we describe is the incompatibility between financial stability, capital mobility, and fixed exchange rates. The third extends the analysis to politics and looks at the strains inherent in reconciling democratic politics with monetary autonomy and capital movements. Finally, we examine the security aspect and look at the interaction of democracy with capital flows and international order. These four trilemmas show how domestic monetary, financial, economic, and political systems are connected within the international system. They can be described as the impossible policy choices at the heart of globalization. Frequently, the trilemmas conjure up countervailing antiglobalization tendencies and trends, as we describe in this chapter.

In practice, as scholars investigating the exchange rate trilemma have demonstrated, it is empirically hard to determine a pure policy stance: there are varying degrees of commitment to a fixed exchange rate regime, varying degrees of openness to international capital, and varying extents of monetary autonomy (Obstfeld, Shambaugh, and Taylor 2005). Thus, in practice, policy is hardly ever positioned at the corners of the trilemma, and actual policy stances fall somewhat in between the corner positions—where the corners simply represent the boundaries of the possible. The discussion of the exchange rate trilemma thus serves as a Weberian ideal type, rather than an exposition of the real world. The same reservation applies to the other trilemmas that we identify: there is obviously neither pure financial stability nor pure instability, no absolute democracy, and no completely binding treaty organization or international system. There are always trade-offs. But identifying the choices as borders can help us define problems and sources of tension and establish potentially effective remedies. Finally, we address forms of cooperation—with regard to financial stability and the building of agreements across borders—that can take the sharp edges off the trilemmas and reduce the likelihood of sudden and traumatic reversals and shocks.

The Macroeconomic Trilemma

The first trilemma is undoubtedly the most familiar of the four sets of issues examined here. Mundell (1963) formalized the point that free capital movements and a fixed exchange rate rule out the possibility of conducting independent monetary policy. Padoa-Schioppa (1994) reformulated this proposition as the “inconsistent quartet” of policy objectives by bringing in commercial policy, another central part of the globalization package: free trade, capital mobility, fixed or managed exchange rates, and monetary policy independence. In both the Mundell and Padoa-Schioppa formulations, the impossible choice provided a rationalization for building a more secure institutional framework to secure cross-border integration, especially to deal with the problem of small or relatively small European countries. Both were major architects of the process of European monetary union. They justified this step of further integration on the grounds that the exchange rate was a useless instrument—the monetary equivalent of a human appendix or tonsils—that could be usefully and painlessly abolished. However, some countries continued to regard the exchange rate as a useful tool for obtaining trade advantages.

The policy constraint following from free capital movements has recently been posed in a more severe form by Rey (2013), who shows that in a globalized world of free capital movements, monetary policy is limited even with flexible or floating exchange rates. A choice to have a floating exchange rate thus does not give a free pass to monetary policy. Rey identifies “an ‘irreconcilable duo’: independent monetary policies are possible if and only if the capital account is managed, directly or indirectly, via macroprudential policies” (287). This argument does not necessarily lend itself to the demonstration of the necessity of monetary union: If the aim is to preserve national policy autonomy, a better choice is to control capital movements, as was envisaged in the 1944 Bretton Woods Conference and provided for in the Articles of Agreement of the International Monetary Fund. Capital movement across borders—through both inflow surges and the consequences of reversals—may fundamentally limit the scope of national monetary policy. Since the 2008 global financial crisis, the articulation and elaboration of macroprudential policies has become a way of trying in practice to limit or manage the extent to which capital may be mobile; consequently, the discussion of the monetary policy trilemma leads in a straightforward way to the discussion of financial policy issues.

Capital mobility, however, continues to be attractive. Financially constrained borrowers—corporations as well as governments—see capital inflows as a way of obtaining access to financial resources. In addition, the inflows may be linked to institutional innovation and governance reform. After waves of overborrowing, the costs may be clearer: capital flows, in the nice analogy of Stiglitz (1998), generate such large waves as to upset the delicate rowing boats of small countries afloat on the sea of globalization. But many participants in the process quickly forget the possibility of the large waves and tides.

The logic of the original Mundell trilemma (Figure 5.1) thus points either in the direction of closer cooperation (including perhaps political arrangements that constrain domestic choices) or toward capital controls as a way of rescuing national policy autonomy. In light of the gains that may be lost as a result of capital controls (and of an awareness of the necessarily incomplete character of capital controls that makes them prone to evasion), the process of globalization requires cooperation and coordination.

Figure 5.1.The Macroeconomic Trilemma

Source: Authors’ illustration.

The Financial Stability Trilemma

The new formulation of the constraints on monetary policy follows from evidence of the enhanced volatility induced by the financial sector, and the proclivity of the world to lurch into credit cycles of large amplitude. Financial (particularly banking) stability is incompatible with capital flows, when exchange rates are fixed and create misleading incentives for capital to move.

To understand the character of the constraint, we must reflect on the origins of the new sources of financial instability. The formulation of the classical macro-economic trilemma says little about the sequencing of policy measures. The original Mundell formulation implies that policy formulation began in an idealized nineteenth-century world, in which capital mobility and a fixed metallic exchange rate were assumed and central banks mechanically responded to gold inflows or outflows by loosening or tightening monetary policy. The third element—a flexible monetary policy—is necessarily ruled out if the rules of the game are followed. Indeed, almost no nineteenth-century analyst depicted monetary policy as a discretionary instrument. But this approach does not describe nineteenth-century reality. Most countries, in fact, engaged in considerable experimentation with the monetary standard (Bloomfield 1959); it was only in the last decades of the century that the gold standard became a nearly universal norm.

Why did the gold standard appear attractive? Countries adopted it (as they would later engage in fixed exchange rate arrangements) mostly in the hope that it would enhance their credibility, provide a “good housekeeping seal of approval” (Bordo and Rockoff 1996), and attract substantial capital inflows (Obstfeld and Taylor 2004). A stable exchange rate could be used to compensate for inadequate availability of domestic capital. The beneficial effect of an inflow of foreign capital would be realized only if the domestic financial system started to intermediate the new flows; thus, domestic financial expansion or the beginning of an expansive financial cycle was a consequence of regime choices.

Such domestic financial expansion often (but not always) occurred on an inadequate institutional basis; indeed, financial underdevelopment and inexperience were often the very flaws the policy choice was intended to correct. But underdeveloped financial systems had little experience in managing credit allocation or running banks. Countries wanted to adopt the gold standard in the nineteenth century (or open their capital accounts in the late twentieth century) to develop their financial institutions, but the resulting financial inflows often increased the vulnerability of fragile domestic institutions. However, as long as the inflows persisted, they sustained a false confidence that additional capital was indeed producing more stable and mature financial systems.

Eventually a learning process about finance set in. It took time for countries to adapt their institutions to the capital inflows and the risks of crises. In many cases, countries failed to adapt efficiently and capital flows simply reinforced existing rent-seeking and corrupt institutions (Haber and Calomiris 2014). In these cases, capital inflows increased rather than decreased vulnerability.

The interplay of international capital movements and a weak banking system in emerging markets has been a constant source of major international financial crises. Well-known examples include the United States in the 1830s, Argentina in the late nineteenth century, central Europe in the 1920s, some emerging Asian countries in the 1990s, and southern Europe in the 2000s. In many cases, the surge of capital also produced fiscal crises in the aftermath of excessive public debt issuance, driven by bailouts of insolvent banks or by explicit or implicit guarantees. Some countries attempted to compensate for financial instability by providing government guarantees that, in the end, involved promises that could not be fulfilled and only enhanced financial instability.

In the late 1830s, US states went on a borrowing spree. At the same time, President Andrew Jackson launched a Bank War, in the course of which he vetoed the rechartering of the Second Bank of the United States (a powerful institution that controversially combined central banking with commercial banking functions) and encouraged other banks to seek charters. Jackson achieved his immediate objective of decentralizing credit. But then the new banks (the “pet banks” as they were disparagingly called) immediately expanded lending, primarily to the states and the political elites that had facilitated their establishment. The upshot was an orgy of bank credit to individual states, often structured in a complex way so that debt securities could be repackaged and sold on foreign markets. Beginning in 1841 the borrowing states started to default, and the banks themselves were brought down by bank runs.

At the end of the nineteenth century, the 1890 bankruptcy of Argentina triggered a rethinking of how capital flows were handled. At the time Argentina was the world’s largest borrower in terms of share of GDP, with “some of the most spectacular capital inflows of the history of the world economy” (Taylor 2003, 178). A modern calculation suggests that Argentina imported capital amounting to 18.7 percent of its GDP between 1870 and 1889 (Flandreau and Zumer 2004); by the 1880s Argentina accounted for almost half of British foreign lending (Ford 1962; Mitchener and Weidenmier 2008). The availability of foreign money prompted a fiscal expansion and general economic overheating. In parallel, the 1887 Law of National Guaranteed Banks is a fine example of a law that appears to constrain banking activity and thus guarantee stability, but in practice it led to a bank glut. Under the law, banks were required to buy National Gold Bonds issued by the Treasury as a requirement for note issue. The banks raced to borrow as much as they could on foreign markets, mostly in London, and deposited the gold with the Treasury. They could then use the banknotes as a basis for domestic credit expansion. After 1887 money creation surged (Cortes Conde 1989; della Paolera and Taylor 2007). Price increases made Argentina uncompetitive, tax revenue fell off, and a debt crisis erupted in 1890.

Banks in central Europe had their capital largely wiped out by hyperinflation in the aftermath of World War I. Stabilization involved returning to the gold standard with the expectation that this would make financially and fiscally stricken countries the recipients of capital inflows. In the course of postwar inflation and hyperinflation, central European bank capital had been destroyed; in the stabilization of the mid-1920s, banks began with severely reduced levels of capital relative to their prewar position. It was expensive to raise new capital, and new lending occurred on a very thin capital basis. Banks also found it much harder than before the war to attract retail deposits, so they funded lending with interbank credit—both from domestic sources and from international borrowing, largely from the United States (Kindleberger 1973; Eichengreen 1992). The external source of finance drove banking expansion in Germany and elsewhere. It was only at the height of the credit boom that bank loans relative to GDP reached prewar levels (which were high in an international comparison). Paradoxically, this reflection on catch-up offered one ground for creditors to believe that their claims might be secure (Balderston 1993). The vulnerability was increased by the persistence of a German prewar tradition of considering the central bank as a lender of last resort and a belief that the government would ultimately step in to guarantee debt. That represented the most fundamental flaw in the domestic policy regime. The safety net provided by the Reichsbank allowed a thinner capital basis and gave both the banks and their creditors misguided confidence (Schuker 1988; James 1999). The expansion of borrowing by central European banks occurred in an informational or statistical fog (BIS 1932, 1934). The vulnerability of the banks—in a banking crisis that accompanied a currency crisis—was a major cause of the financial collapse in 1931 and the reversal of capital flows (James 1986; Schnabel 2004).

The 1997 East Asian financial crisis had its origins in financial liberalization, when in 1993 the Thai government established the Bangkok International Banking Facility, allowing a substantial number of domestic and foreign banks to operate an international banking business. These banks engaged in heavy foreign exchange borrowing, which they then used to expand credit domestically. Again there were implicit guarantees of the foreign currency exposure of the banks, as it was (correctly) believed by the foreign creditors that the borrowing banks were too important to fail (Dooley 2000).

The introduction of the euro in 1999 prompted a surge of capital into southern Europe, as well as Ireland. As in Asia in the 1990s, there were large current account deficits and, as in east Asia, there were in some cases imbalances that were limited to the private sector, with the public sector fiscal position appearing strong in countries, and with a borrowing surge (notably, Ireland and Spain). There was also great confidence that the inflows were modernizing and building more resilient financial and indeed political systems. Investors also assumed some sort of implicit guarantee. As a prominent Greek politician, Yiannos Papantoniou, explained in 2005, “Greece completed a cycle of substantial modernization over the previous decade. Overcoming the economic instability and stagnation of the previous era, it managed to consolidate its finances, reduce inflation, accelerate growth and promote structural changes conducive to a friendlier environment for enterprise and investment” (Lynn 2011, 54). Political scientists spoke of the Europeanization and modernization that allowed Greece to morph into a “first-rate liberal democracy with a good economy” (Kalaitzidis 2009, 1).

The general lessons from these historical episodes is that liberalized financial systems weaken financing constraints, thereby providing more room for the buildup of financial imbalances (Borio, James, and Shin 2014). Not every surge of foreign lending had the same effect: Canada was able to digest capital inflows, and sustain a long current account deficit in the nineteenth century, without incurring financial fragility.

The most extreme cases of the damaging effects of capital inflows occur in fixed exchange rate regimes (the nineteenth-century gold standard, Europe in the 1920s, the Asian boom of the 1990s) or in a monetary union (Europe in the 2000s). Thus it is sometimes argued that a flexible exchange rate curbs the excesses, as capital inflows bring an exchange rate appreciation that lowers trade competitiveness and reduces the attractiveness for new inflows. But this approach blocks off many of the potential beneficial effects that borrowers expect to obtain from the inflow of capital.

After a series of financial crises around the world, the problem has been discussed as an issue of appropriate sequencing: that is, the wisdom of building stronger domestic institutions before seeking mechanisms to encourage capital inflows. A country should not open a capital account until it has deepened its domestic financial system; otherwise, the inflow of money might create financial imbalances. But this argument misses the fundamental point that the domestic system may never develop adequately on its own; it needs external resources. In a sense, then, financial instability is inherent to the development process. Opening the capital account in a fixed exchange rate regime is hard to reconcile with financial stability. This logic leads us to the second trilemma (Figure 5.2).

Figure 5.2.The Financial Stability Trilemma

Source: Authors’ illustration.

The Political Economy Trilemma

After a period of financial opening, the consequent development of financial imbalances may strain the political system. States (whether they are autocracies or democracies) initially like the benefits of open capital markets. Democracies, in which governments are responsive to the short-term demands of voters, are also likely to want to set monetary policy independently. They need to work out a trade-off between present monetary autonomy and the ability to attract inflows. In addition, both policies have time consistency problems of a different character. First, the monetary stimulus will bring immediate benefits only if it is unanticipated; if there is an expectation that the behavior will be repeated, agents will build the future into their responses to the stimulus. The stimulus relies on the noncontinuation of the policy. Second, by contrast, capital inflows may also bring short-term effects, but if there is a sudden stop, investment projects will remain unfinished and repayment will be problematic. The benefits rely on the expectation that the flows will continue. But states, especially democratic states, find it hard to commit to policies that will lock in the institutional basis on which long-term inflows can occur; there is instead an incentive to derive simply short-term advantages (such as those following from monetary stimulus) and leave the longer- term problems to successor governments.

The economic and financial problems that arise when capital inflows end or reverse can be severe. The collapse of unstable financial structures has immediate and severe economic effects that may include most or all of the following features: bank collapses, withdrawal of bank credits, rise in bankruptcies, collapse of prices, and rise in unemployment. In a celebrated article by Irving Fisher (1933), these effects were referred to as “debt-deflation.” In Fisher’s presentation there was no lender of last resort, but even with a lender of last resort and deposit insurance, guarantees and rescues can lead to fiscal crises.

While capital inflows continue and the financial imbalances build up, the system looks as if it is politically attractive and stable. Indeed, political parties often make compromises to support governments that can promise the institutional reforms needed to allow the inflow of capital to continue. Because inflows are generally the result of external financial conditions, they should not be interpreted as a response to particularly suitable or well-designed economic policies; but that is how they are commonly interpreted by voters, who view economic success as a key determinant in their choice (Kayser 2009). In practice, large inflows may weaken effective economic policymaking, because they relax the constraints under which governments operate and because the generally rising tide means that signals are suppressed that might indicate problematic features of the economy (Fernández-Villaverde, Garicano, and Santos 2013). Capital flows thus may suppress basic signals about government effectiveness that are essential to the functioning of democracy, because voters are not correctly informed about the level of competence of their governments. Warning against the potentially deleterious effects is a business that is unattractive, and left to outsiders, who make Cassandra-like prophecies. The insiders who benefit from inflows can in aggregate behave to ridicule the Cassandras.

However, when financial strains appear as a result of capital account openness, political parties no longer wish to be associated with the consequences. Voters blame the parties that have been associated with power for their past mistakes and flock to parties that define themselves as being against the system. In modern parlance, these parties are often described as “populist.” The populist parties may be on the left or on the right; in fact, most antisystem parties combine elements of a left-wing and a right-wing critique of the system they are trying to overthrow. The left-wing critique is that the burden of crisis adjustment of incomes and wealth falls unequally and unfairly on the poor. The right-wing critique emphasizes that the adjustment works to the benefit of foreign creditors and represents a derogation of national sovereignty. These opposing arguments are not really contradictory; they can be (and are) easily combined. In these circumstances, the democratic principle is simply recast as a defense of national sovereignty.

Examples of the disintegration of traditional party systems in the aftermath of severe financial turbulence can be found in twentieth-century history and in the contemporary euro crisis. The Great Depression produced disintegration of democratic systems in central and eastern Europe and Latin America. The iconic case of democratic failure is that of Weimar Germany, which had a constitution and political system that had been carefully designed by distinguished political theorists (notably Max Weber and Hugo Preuss) to be as perfect a reflection as possible of popular voting preferences: the system featured both a direct election of the president and proportional representation designed so that there would be no “lost” votes. However, the parties committed to democracy progressively lost voting shares, and the parties associated with government lost especially badly. By the time of the Great Depression, both the center-left (the Social Democratic Party) and the center-right (the Democratic Party and the German People’s Party) had lost significantly and were no longer capable of commanding a parliamentary majority. In terms of policy, the governments could do little, and their policy options were profoundly limited (Borchardt 1991).

The disintegration of system parties in the face of economic constraints is also a key element in the modern financial and political crisis in Europe. In Greece, the center-right New Democracy was defeated in elections in October 2009 and succeeded by the center-left Pasok (with 43.9 percent of the vote). Pasok was then discredited by its negotiations with creditors and by the wavering of Prime Minister George Papandreou on whether to hold a referendum on the terms of the plebiscite. After new elections in May 2012 (which were inconclusive) and June 2012, New Democracy returned to head a coalition government. The center-right party had only 29.7 percent of the vote, and it depended on Pasok, which had collapsed to 12.3 percent and had been squeezed into third place by the radical left, populist Syriza party. In January 2015, votes for New Democracy had shrunk to 27.8 percent and Pasok to 4.7 percent; Syriza, with 36.3 percent, could form a government with a populist right-wing party (Independent Greeks, 4.8 percent of the votes).

Likewise, in Spain, in the November 2011 elections, the socialists who had been in government in the first part of the financial crisis were punished with a fall in the vote from 43.9 percent to 28.8 percent, and power changed to the center-right Popular Party. But by 2015 the latter was threatened by a populist left party, Podemos, which used Syriza as a model. In Italy’s 2013 elections, the party of Silvio Berlusconi, which had formed the government in the first phase of the crisis, won 29.1 percent of the vote and narrowly lost to the center left (29.5 percent). By 2014 in European Parliament elections, Berlusconi’s movement was in third place with only 16.8 percent of the vote, and a populist leftist movement headed by comedian and political activist Beppe Grillo had 21.2 percent of the vote (it had done even better in the 2013 elections to the Italian parliament). The technocratic prime minister, Mario Monti, who had stepped in when Berlusconi’s government collapsed under international pressure, founded a new political party (Civic Choice) but got only 8.3 percent of the vote in 2013—a showing similar to that of the liberal parties in the late years of Weimar Germany.

Even if the antisystem parties do not succeed in gaining majorities, their enhanced electoral support and the ensuing political pressure push the old or traditional parties to take a less accommodating and more radical stance.

In hard times—when politicians demand sacrifices from their voters—they often explain their position by saying that their hands are tied. While that may be a plausible argument in very small countries, the larger the country, the less compatible this stance is with the idea of national sovereignty. Consequently, the demand for an enhanced national sovereignty appears as a frequent response to setbacks, and even small countries may rebel. As Greece’s flamboyantly radical finance minister Yanis Varoufakis put it in 2015, “The notion that previous Greek governments signed on the dotted line on programmes that haven’t worked, and that we should be obliged to just follow that line unswervingly, is a challenge to democracy.”1

The demand for national policy autonomy affects the policy equilibrium that arises out of the first trilemma. But when monetary independence could lead to the possibility of short-term stimulus at the cost of longer-term credibility, such autonomy would be undesirable. Monetary independence would lead to political pushes to manipulate monetary policy for short-term advantages without providing any long-term gains. The Mundell trilemma in these circumstances points in the direction of constraining national monetary autonomy. If the outcome of a likelihood of turning to a more national monetary policy is known in advance, it will influence investors’ calculations. They will see commitment to a gold standard or fixed exchange rate regime as ultimately lacking credibility.

The possibility of such a reversal seemed less likely in the nineteenth century, at the time of the classic gold standard. In fact, investors often made the argument that the extension of constitutional rights was more rather than less likely to protect their rights. The phenomenally successful banking house of Rothschild consistently pressed for political reforms, imposing a sort of political conditionality (Ferguson 1999). The people who were represented in parliaments were on the whole creditors; making policy dependent on their assent meant ruling out the possibility of an expropriation of creditors. However, as the franchise was extended, parliaments no longer reflected a preponderance of creditors; they came more and more to represent groups that benefited from state transfer payments. Such payments stood as alternative claims on the public purse to the requirement to service debt. The experience of the first major cycle of the political process in which democracy turned against creditors led Polanyi (1944) to make the famous argument that the gold standard (and, by implication, analogous regimes) was impossible in a democratic age.

The memory of the politics of turning against creditors during the Great Depression faded as the credit supercycle emerged in the second half of the twentieth century, when the argument began to resurface about the compatibility of globalization with democracy in emerging markets (Eichengreen 1996). Rodrik (2000, 2007) formulated the point in this way as a general argument about the incompatibility of hyperglobalization, democracy, and national self-determination: “democracy, national sovereignty and global economic integration are mutually incompatible.” He presented the European Union as the best template of a new form of global governance with supranational rulemaking (Rodrik 2011). After the global financial crisis, the same problems and policy dilemmas appeared in rich industrial countries, and globalization appeared vulnerable again.

Democratic politics can be thought of as evolving two sorts of operations: the formulation of laws based on general principles of conduct, and redistribution of resources. The capacity to redistribute is limited if there is a large cross-border mobility of factors of production: capital is most obviously mobile, and it escapes if rates of capital taxation are too high; but the same process may also hold true in the case of taxation of high incomes, and income earners will try to operate in a different national and tax setting. Even the capacity to formulate general laws may be limited, in that incompatible principles in different countries may produce anomalies or loopholes and possibilities for forum-shopping.

Politicians are often painfully aware of the restraints. Jean-Claude Juncker, the veteran prime minister of Luxembourg and current president of the European Commission, formulated the constraint in the following way: “Politicians are vote maximisers … for the politician, the Euro can render vote-maximising more difficult, as a smooth and frictionless participation in the monetary union sometimes entails that difficult decisions have to be undertaken or that unpopular reforms have to be initiated” (Marsh 2011, 269). The third trilemma (Figure 5.3) can thus be formulated as the incompatibility of capital flows, independent monetary policy, and democracy. This incompatibility poses a severe problem for people who believe that a major area of policy in a modern state should be capable of being decided by a democratic process.

Figure 5.3.The Political Economy Trilemma

Source: Authors’ illustration.

The International Relations Trilemma

Democracies like international order when it helps them attract beneficial capital inflows. But both capital mobility (as we have seen) and the limits imposed by international order narrow the scope for democratic politics.

The “tied hands” argument with regard to ensuring that democratic decisions were compatible with a longer-term framework of stability was frequently presented in the form of treaties or security arrangements. Often the reassurance creditors needed to convince them to lend was political rather than simply a monetary commitment mechanism (such as participation in the gold standard, an exchange rate mechanism, or the monetary union). Alliances offered investors the security that creditor governments would put pressure on banks to continue lending, and hence reduced the likelihood of sudden stops. The search for credibility might lead to a security commitment, in which countries would seek ties with powerful creditor countries because of the financial benefits. This kind of argument about the security bulwark that locks in capital movements applies to both democratic and nondemocratic regimes.

In addition, in democratic societies the redistributory impulse generated by the political process may—especially when the limits of domestic redistribution become apparent—translate into a wish to redistribute the resources of other countries. The burden of an unpleasant adjustment could conceivably be shifted onto other people who are outside the national boundary and thus outside the political process. It is this impulse (“Let the others pay!”) that is restrained by treaties and security commitments. An alliance system or closer political union (as in modern Europe) helps restrain destabilizing democratic impulses, in which one country’s democratic choices conflict with the voting preferences of other democracies.

Like all the other mechanisms involved in the various trilemmas, the security relationship too thus may reverse. If the security regime were severely challenged, the gain in credibility would no longer look attractive. And if capital flows reversed or financial fragility appeared, there would be fewer gains from participating in the international order. Potential borrowers that had locked themselves into security or other cooperative arrangements would then be tempted to defect.

The story of how diplomatic commitments enhance credibility is especially evident in the well-known example of Russia: a nondemocracy or autocracy locking into international security commitments. The beginning of the diplomatic rapprochement between Russia and France in 1891 was accompanied by a French bond issue, which the supporters of the new diplomacy celebrated as a “financial plebiscite” on the Franco-Russian alliance. Russia survived a sharp contraction in 1900–01 as well as a political crisis, with war and revolution in 1905, with no default. It raised new money immediately after the revolution of 1905. By 1914 almost half of the Russian government’s 1,733 million ruble debt was held abroad, with 80 percent in French hands and the United Kingdom holding 14 percent. The diplomatic, military, and financial calculations were intricately entwined, and were skillfully used by Russia as a way of locking in the creditors politically and economically (Siegel 2014).

In imperial systems (which again are nondemocratic), the imperial security umbrella, coupled with the extension of legal principles from the metropol, functioned in a similar way and reassured investors that the country was capable of sustaining greater debt levels. The effect has been attributed to imperial order, but it is hard to determine whether it is due more to the effects of good policy, imposed as a result of reform-minded administrators, or to the power of the empire to compel repayment (Ferguson and Schularick 2006). In the aftermath of some crises, the imperial system simply expanded to swallow up bankrupt debtor entities; well-known examples are Egypt in 1875 and Newfoundland in 1933. But even very large and powerful political units have sought financial shelter by embracing financially stronger powers. In an extreme example, in early 1915 the Russian government suggested a fiscal and political union with France and the United Kingdom to allow it continued access to credit markets (Siegel 2014).

When capital dries up, incentives to make international commitments also disappear. Interwar Italy is a good case of the consequences of the logic of the reversal—when the international system no longer promises large financial gains. When the capital market was open in the 1920s, the fascist dictatorship of Benito Mussolini stabilized its currency and entered a fixed exchange rate regime (the quota novanta). Mussolini also moderated his foreign policy and suppressed any proclivity for political adventurism. When the international financial system broke down in the banking crisis of 1931, foreign policy restraint no longer offered any financial benefits, so Mussolini reoriented his policy toward imperial expansion. Adolf Hitler proposed a similar response to the Great Depression: Germany should break with international constraints and enrich itself at the expense of neighboring countries. Thus, a reversal of the gains that follow from security commitments is likely to be associated with a backlash against democratic politics.

There are more modern variants of the same process. After private capital flows in Europe from north to south halted in 2008, many southern Europeans lost their enthusiasm for European integration and turned against both the euro and the European Union.

The case of modern Russia is even more striking. Initially Russian President Vladimir Putin seemed to be a rather pro-Western, modernizing leader who sought engagement with the world economy, which included access to capital markets that would allow Russia to develop. Before 2008 Russia acquiesced to the logic of global capitalism; it needed to cooperate with global multinational companies to build an economy based on raw material and energy production, as well as technologies to process the raw materials.

But in 2007–08, Russia’s strategy changed. On the eve of the global financial crisis, Putin spoke to the annual Munich Security Conference about the new power potential of the BRICs (Brazil, Russia, India, and China) as an alternative to what he dismissed as an arbitrary “unipolarity.” His audience was shocked, and many saw the speech as evidence of insecurity or irrationality. However, as the financial crisis spiraled out of control, Putin reached the conclusion that he had been prophetic. After the crisis (if one follows power logic instead of the logic of economic growth) there was no longer so much to be gained from global markets. Instead, the best game in town was to cooperate with other countries with more state-centered capitalism, notably China.

In a world in which capital links do not bring mutual gains, democratic politics in each country can look as though it is targeted against other countries. Varoufakis offers a striking instance of this analysis when he refers to lessons from ancient Greece and its warring states: “Sometimes the larger, powerful democracies undermined themselves by crushing the smaller ones.”2 The fourth trilemma (Figure 5.4) can thus be formulated: that capital flows, democracy, and a stable international political order cannot be reconciled with each other.

Figure 5.4.International Relations Trilemma

Source: Authors’ illustration.


The multiple trilemmas may not be the apparently impossible policy strait-jackets they seem to represent. In practice, there are always intermediary solutions; in the original macroeconomic version, there is never pure capital mobility or pure monetary policy autonomy. Some restrictions on capital mobility—even the home preference of investors or increased macroprudential controls on banking—provide room for policy maneuver. Policymakers are always making practical trade-offs.

Such an approach also indicates how practical responses to the other three trilemmas are likely to evolve. Capital mobility is central to all the trilemmas, so it might be tempting to recast the story in terms of the conclusion that capital mobility is simply not worth it (Stiglitz 1998; Bhagwati 2004). In practice, the historical experience shows that turning away from capital mobility is not that easy, and it carries an economic and political cost. Capital mobility is part of modern globalization. It is the apple in the Garden of Eden: irresistibly attractive but the cause of problems and misery. Once tasted, it is hard to spit the apple out again.

If financial stability is to be compatible with increased capital mobility, there must be more policy coordination on financial stability issues. Since 2008, such coordination has been a priority in international discussions of the Financial Stability Board (established in 2009 as a successor to the Financial Stability Forum in the wake of the Asian financial crisis). But the task of coordination is always challenged by national regulatory solutions that respond to particular local circumstances.

Absolutely irreversible fixed exchange rates—for instance, in a monetary union—require a high degree of political coordination, if not necessarily a political union. In the nineteenth century and until 1914 the gold standard economic world coexisted with political stability underpinned by an increasingly precarious international alliance system. The failure of the alliance system to contain conflict in 1914 ended the economic calculations of gold standard participants, and currency convertibility was suspended in almost every state. In the 1920s an attempt was made to restore the gold standard and to build order through the League of Nations. After 1945, in the Bretton Woods order, democracies were less constrained, as there were effective limits on capital movements. The opening of capital markets required a greater realism on the part of participants in a democratic process.

Democratic politics will not work when too many promises are made. Realistic democracy involves a commitment to longer-term sustainability. Sustainability is always threatened by rapid changes of policy or by policy inconsistency. Some commentators identify a fundamental “economic policy problem.” Democratic societies find credible commitment to a long-term policy almost impossible, even with a broad consensus that such a long-term orientation would be desirable. Political scientists point out that no adequate mechanisms exist to reward current majorities for future economic performance: that is, policies that entail a current cost with payoffs that do not occur until several electoral terms in the future. Some suggest that one of the reasons fiscal reform and consolidation may work better in the United Kingdom than in the United States is that a five-year electoral cycle gives a longer horizon than a four-year cycle punctuated by midterm elections. The difficulties lie in part in the fact that present pain and future gain have often been misused as political slogans, and there is therefore a great deal of public cynicism about them. In addition, the relationship between present policy and future economic outcomes is not well understood, which leads to arguments about notions of a “free lunch” in the case of monetary policy where low interest rates are supposed to deliver greater growth, employment, and prosperity levels or in fiscal discussions that suggest that more spending and larger deficits can shift an economy from a bad to a good equilibrium.

Multilateral institutions can be thought of as commitment mechanisms that improve the quality of democracy by limiting the power of special interest organizations and by protecting individual rights (Keohane, Macedo, and Moravcsik 2009). The international relations trilemma is thus potentially solvable in the same way: through the evolution of a longer-term framework of stability. International commitments—the foundation of a stable international order—can lock in particular domestic settlements and ensure a longer-term framework of stability. The Bretton Woods international regime is often rightly regarded as a mechanism by which the United States internationalized the New Deal settlement (Ikenberry 2001).

Considering a broader concept of democracy in an international setting reduces the political logic of a zero-sum game mentality in which one country’s gains can be achieved only through losses imposed on others. A larger security umbrella can therefore provide a framework for a system of rules about capital movement and a framework for stability that would limit or circumscribe the destructive capacity of capital-inflow-fueled credit booms.

But such grand compacts (of which the best historical example is the 1944–45 settlement that included Bretton Woods) are hard to achieve without a substantial amount of fear and uncertainty. The equivalent today of the time pressure that existed at the end of World War II is an urgent but also uncontrollable global crisis. The sad lesson of Bretton Woods is that things need to be extremely dangerous before a political dynamic of reform develops. It may be that today’s world, for all its anxieties, is simply not obviously dangerous enough and that policymakers are too secure about the permanence of the globalization phenomenon.


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1Financial Times, February 2, 2015, “Greece Finance Minister Reveals Plan to End Debt Stand-off.”
2Financial Times, February 7, 2015, “An Athenian Boxer Fights the Good Fight.”

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