Greek lessons for world economy

Democracy, nation-state and globalisation can't go together; we can have at the most two at one time, says Dani Rodrik.

The $140-billion support package that the Greek government has finally received from its European Union partners and the International Monetary Fund gives it the breathing space needed to undertake the difficult job of putting its finances in order.

The package may or may not prevent Spain and Portugal from becoming undone in a similar fashion, or indeed even head off an eventual Greek default. Whatever the outcome, it is clear that the Greek debacle has given the EU a black eye.

Deep down, the crisis is yet another manifestation of what I call "the political trilemma of the world economy": economic globalisation, political democracy, and the nation-state are mutually irreconcilable. We can have at the most two at one time.

Democracy is compatible with national sovereignty only if we restrict globalisation. If we push for globalisation while retaining the nation-state, we must jettison democracy. And if we want democracy along with globalisation, we must shove the nation-state aside and strive for greater international governance.

The history of the world economy shows the trilemma at work. The first era of globalisation, which lasted until 1914, was a success as long as economic and monetary policies remained insulated from domestic political pressures.

These policies could then be entirely subjugated to the demands of the gold standard and free capital mobility. But once the political franchise was enlarged, the working class got organised and mass politics became the norm, and domestic economic objectives began to compete with (and overwhelm) external rules and constraints.

The classic case is Britain's short-lived return to gold in the interwar period. The attempt to reconstitute the pre-World War I model of globalisation collapsed in 1931, when domestic politics forced the British government to choose domestic reflation over the gold standard.

The architects of the Bretton Woods regime kept this lesson in mind when they redesigned the world's monetary system in 1944. They understood that democratic countries would need the space to conduct independent monetary and fiscal policies.

So, they contemplated only a "thin" globalisation, with capital flows restricted largely to long-term lending and borrowing. John Maynard Keynes, who wrote the rules along with Harry Dexter White, viewed capital controls not as a temporary expedient but as a permanent feature of the global economy.

The Bretton Woods regime collapsed in the 1970's as a result of the inability or unwillingness -- it is not entirely clear which -- of leading governments to manage the growing tide of capital flows.

The third path identified by the trilemma is to do away with national sovereignty altogether. In this case, economic integration can be married with democracy through political union among states. The loss in national sovereignty is then compensated by the "internationalisation" of democratic politics. Think of this as a global version of federalism.

The United States, for example, created a unified national market once its federal government wrested sufficient political control from individual states. This was far from a smooth process, as the American Civil War amply demonstrates.

The EU's difficulties stem from the fact that the global financial crisis caught Europe midway through a similar process. European leaders always understood that economic union needs to have a political leg to stand on.

Even though some, such as the British, wished to give the Union as little power as possible, the force of the argument was with those who pressed for political integration alongside economic integration. Still, the European political project fell far short of the economic one.

Greece benefited from a common currency, unified capital markets, and free trade with other EU member states. But it does not have automatic access to a European lender of last resort.

Its citizens do not receive unemployment checks from Brussels the way that, say, Californians do from Washington DC, when California experiences a recession. Nor, given linguistic and cultural barriers, can unemployed Greeks move just as easily across the border to a more prosperous European state.

And Greek banks and firms lose their creditworthiness alongside their government if markets perceive the latter to be insolvent.

The German and French governments, for their part, have had little say over Greece's budget policies. They could not stop the Greek government from borrowing (indirectly) from the European Central Bank (ECB) as long as credit rating agencies deemed Greek debt creditworthy.

If Greece chooses default, they cannot enforce their banks' claims on Greek borrowers or seize Greek assets. Nor can they prevent Greece from leaving the eurozone.

What all this means is that the financial crisis has turned out to be a lot deeper and its resolution considerably messier than necessary. The French and German governments have grudgingly come up with a major loan package, but only after considerable delay and with the IMF standing on their side.

The ECB has lowered the threshold of creditworthiness that Greek government securities must meet in order to allow continued Greek borrowing.

The success of the rescue is far from assured, in view of the magnitude of belt-tightening that it calls for and the hostility that it has aroused on the part of Greek workers. When push comes to shove, domestic politics trumps foreign creditors.

The crisis has revealed how demanding globalisation's political prerequisites are. It shows how much European institutions must still evolve to underpin a healthy single market. The choice that the EU faces is the same in other parts of the world: either integrate politically, or ease up on economic unification.

Before the crisis, Europe looked like the most likely candidate to make a successful transition to the first equilibrium -- greater political unification. Now its economic project lies in tatters while the leadership needed to rekindle political integration is nowhere to be seen. 

The best that can be said is that Europe will no longer be able to delay making the choice that the Greek affair has laid bare.  If you are an optimist, you might even conclude that Europe will, therefore, ultimately emerge stronger.

The author is professor of Political Economy at Harvard University's John F Kennedy School of Government, is the first recipient of the Social Science Research Council's Albert O Hirschman Prize. His latest book is One Economics, Many Recipes: Globalisation, Institutions, and Economic Growth. Project Syndicate, 2010