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Greek Lessons for the World Economy

Dani RodrikCAMBRIDGEThe $140 billion support package that the Greek government has finally received from its EuropeanUnion partners and the International Monetary Fund gives it the breathing space needed to undertake the difficult jobof putting its finances in order. The package may or may not prevent Spain and Portugal from becoming undone in asimilar fashion, or indeed even head off an eventual Greek default. Whatever the outcome, it is clear that the Greekdebacle 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 globalization, political democracy, and the nation-state are mutually irreconcilable. We can have at mosttwo at one time. Democracy is compatible with national sovereignty only if we restrict globalization. If we push forglobalization while retaining the nation-state, we must jettison democracy. And if we want democracy along withglobalization, 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 globalization, which lasted until1914, 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 capitalmobility. But once the political franchise was enlarged, the working class got organized, and mass politics becamethe norm, domestic economic objectives began to compete with (and overwhelm) external rules and constraints.

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

The architects of the Bretton Woods regime kept this lesson in mind when they redesigned the worlds monetarysystem in 1944. They understood that democratic countries would need the space to conduct independent monetaryand fiscal policies. So they contemplated only a thin globalization, with capital flows restricted largely to long-

term lending and borrowing. John Maynard Keynes, who wrote the rules along with Harry Dexter White, viewedcapital controls not as a temporary expedient but as a permanent feature of the global economy.

The Bretton Woods regime collapsed in the 1970s as a result of the inability or unwillingness it is not entirelyclear whichof 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, economicintegration can be married with democracy through political union among states. The loss in national sovereignty isthen compensated by the internationalization of democratic politics. Think of this as a global version offederalism.

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 amplydemonstrates.

The EUs difficulties stem from the fact that the global financial crisis caught Europe midway through a similarprocess. European leaders always understood that economic union needs to have a political leg to stand on. Eventhough some, such as the British, wished to give the Union as little power as possible, the force of the argument waswith those who pressed for political integration alongside economic integration. Still, the European political projectfell far short of the economic one.

Greece benefited from a common currency, unified capital markets, and free trade with other EU member states. Butit does not have automatic access to a European lender of last resort. Its citizens do not receive unemployment

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checks from Brussels the way that, say, Californians do from Washington, DC, when California experiences arecession. Nor, given linguistic and cultural barriers, can unemployed Greeks move just as easily across the border toa more prosperous European state. And Greek banks and firms lose their creditworthiness alongside theirgovernment if markets perceive the latter to be insolvent.

The German and French governments, for their part, have had little say over Greeces budget policies. They could

not stop the Greek government from borrowing (indirectly) from the European Central Bank (ECB) as long as credirating 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 considerablymessier 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 at their side. The ECB has lowered the threshold ofcreditworthiness 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 thehostility that it has aroused on the part of Greek workers. When push comes to shove, domestic politics trumpsforeign creditors.

The crisis has revealed how demanding globalizations political prerequisites are. It shows how much Europeaninstitutions must still evolve to underpin a healthy single market. The choice that the EU faces is the same in otherparts 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 rekindlepolitical 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 haslaid bare. If you are an optimist, you might even conclude that Europe will therefore ultimately emerge stronger.

Dani Rodrik, Professor of Political Economy at Harvard Universitys John F. Kennedy School of Government, is

the first recipient of the Social Science Research Councils Albert O. Hirschman Prize. His latest book is OneEconomics, Many Recipes: Globalization, Institutions, and Economic Growth.

Rodrik on Greece: Get It Over With

Dani Rodrik in the Room for Debate at the NY Times:

Get It Over With, by Dani Rodrik: When Argentina defaulted on its debt a decade ago, the country

became a pariah in the eyes of foreign bankers and bondholders and was shut off from

international financial markets. Yet its economy recovered quickly and experienced rapid growth

thanks to a large boost in external competitiveness provided by a vastly depreciated currency. The

lesson is that default can be the better option when the alternative is years of continued austerity.

In the case of Greece, this scenario is greatly complicated by the countrys membership in the euro

zone. Greece would have to exit the euro zone to be able to engineer a currency depreciation.

Since this is something for which euro zone rules do not make any allowance, a unilateral exit will

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unleash huge uncertainty about the rules of the game. And a Greek default will almost certainly be

considered a hostile act by Greeces European partners never mind that German and other euro

zone banks were equally at fault for having over-lent to the Greek government.

Unfortunately, the current strategy seems destined to force Greece to this outcome. It is

predicated on protecting German and other European creditors and bondholders while Greek

workers, retirees and taxpayer pay the bill. This makes no sense economically, and will not work

politically.

One way or another, Germany, France and other euro zone creditor countries are on the hook. If

Greece eventually defaults, they will have to pay for their banks mistakes. It would be far better

for them -- and for the future of the euro zone -- if this reality were recognized quickly. A

coordinated, agreed-upon reworking of the rules will not be easy. But it will do less damage than

insisting on politically unsustainable levels of austerity and having default and exit from the euro

zone forced on the Greek government by protests on the streets.