The System Worked_How the World Stopped Another Great Depression

by Daniel W. Drezner

  The Western-centric nature of international political economy scholarship is hardly a recent complaint. Most Western assessments of how global governance structures handled the Asian financial crisis are disconnected from the assessments of analysts based in the region.44 This is salient because experiencing a weak national economy can affect perceptions of the quality of governance. It is a general rule in public opinion research that a faltering economy causes greater distrust in institutions.45 A weak economy feeds perceptions that the system is not working, institutions are breaking down, and those in authority are not to be trusted. Since economic growth has stagnated in the developed world but not in the developing world, we should see more skepticism about all levels of governance in the OECD economies.

  Indeed, the 2012 Edelman Trust Barometer reflects this phenomenon. It shows that trust of elite institutions is significantly higher in developing countries than in the developed world.46 This is a reversal of pre-crisis findings, which showed lower levels of trust in emerging markets.47 We can also see this in the tenor of most articles and books produced about the financial crisis and global economic governance. As previously noted, the consensus in the West is that the system has failed. In contrast, authors like Kishore Mahbubani or Arvind Subramanian may be skeptical about the prospects of the advanced industrialized democracies, but they are bullish on the future of the global economy and global economic governance.48 The study of global political economy and global economic governance has been anchored in the developed world. Given the weak nature of the post-crisis rebound in these parts of the globe, it should not be surprising that this literature suffers from a pessimism bias.

  Conflating National and Global Governance

  Pessimism about current economic conditions in the developed world might also be causing analysts to conflate poor domestic and regional governance with poor global governance. To be fair, this is a tricky issue to parse. On many dimensions, global governance is the sum of political decisions that are made at the domestic level. A decision to ratify a treaty, file a trade dispute with the WTO, or issue prudential regulation in conformity with Basel Committee rules are all domestic policy acts that are also part and parcel of global governance. However, there is a much larger category of economic policy decisions that are unrelated to global governance and have a more powerful impact on national economic performance. Large-market jurisdictions have far more domestic policy autonomy. This autonomy translates into a greater capacity for domestic policymaking institutions to make mistakes. The primary causes for domestic economic weakness in these countries are not global in origin—and neither are policies at the global level necessarily the best response.49

  Consider the fates of the three largest markets in the developed world: Japan, the United States, and the eurozone. Japan’s economic growth was lackluster long before the start of the subprime mortgage crisis. Ever since its property bubble popped in the early 1990s, Japan’s financial sector has been in a zombie-like status.50 Massive fiscal stimulus throughout the nineties did little to boost Japanese economic growth, though it did increase Japan’s debt-to-GDP ratio. The problems with Japan’s political economy required a much deeper fix. With interlocking institutions based on export-led growth, it has been difficult for successive Japanese governments to find ways to boost domestic consumption. Even “Abenomics,” Prime Minister Shinzo Abe’s radical efforts starting in late 2012 to boost the economy through massive fiscal and monetary expansions has yielded mixed results.51

  By the time the 2008 financial crisis hit, demographic factors had sapped another possible driver of economic growth. A combination of low birth rates and a deep policy aversion to immigration guarantees that Japan’s population will shrink for the rest of this century.52 Political instability has played a role as well: between August 2008 and December 2012, Japan had six prime ministers—most of them politically incapacitated soon after taking office. Little wonder then, that Japanese public trust in government fell by 26 percentage points in the Edelman Trust survey in 2012 alone.53 The aftereffects of the Fukushima nuclear disaster—estimated to cost a quarter of a trillion dollars—did not help matters. Japan’s economy has struggled significantly since the start of the 2008 financial crisis. Its struggles, however, are not closely related to any failure at the global governance level. Most of Japan’s policy problems reside in Tokyo, not elsewhere.

  A similar story can be told about the United States. US economic misfortunes have little to do with either the global economy or global economic governance. Indeed, the United States benefited from the post-crisis global political economy through lower borrowing costs and higher exports. Domestic policy stalemates and political uncertainty, on the other hand, acted as a significant drag on the US recovery from the Great Recession. Political gridlock in the US Congress hampered policymakers throughout the post-crisis period. The average number of Senate filibusters, for example, was twice that of the post–Cold War era.54 After the 2010 midterm elections, when Republicans regained control of the House of Representatives, legislative action ground to a halt. The 112th Congress passed substantially fewer laws than were passed in any session of Congress in the previous half-century. Partisanship also thwarted President Obama’s efforts to appoint Nobel Prize–winning economist Peter Diamond to the Federal Reserve Board of Governors.55

  Even when Washington acted on budgets, taxes, and debt, it did so in a way that maximized the economic trauma. The 2011 debt-ceiling negotiations had significant direct and indirect costs. The US federal government came close to being legally prohibited from borrowing money to finance its operations and pay off maturing debts. Measurements of policy uncertainty were considerably higher during the negotiations than during the 2008 financial crisis; this in turn created a net drag on economic growth.56 The Bipartisan Policy Center estimated that the deadlocked negotiations increased US borrowing costs by more than $18 billion. During the protracted three-month negotiations, consumer confidence plummeted and job creation fell by 50 percent.57 Standard & Poor’s removed the AAA rating from US government debt. The downgrade decision had nothing to do with global market expectations, but rather, according to the agency’s statement, “that the effectiveness, stability, and predictability of American policy-making and political institutions have weakened at a time of ongoing fiscal and economic challenges.”58

  One legacy of the 2011 budget deal was the “fiscal cliff”—a cluster of tax hikes and steep budget cuts that would have been implemented in January 2013 unless Congress acted to stop them. The slow-motion backing away from the fiscal cliff acted as a further drag on the American economy. Producers uncertain of whether tax cuts or government spending would be extended scaled back their business activities, curtailing private-sector investment.59 Another legacy was the automatic sequester of budget cuts in 2013. The architects of the Budget Control Act of 2011 designed the sequester to be suboptimal, assuming that the specter of inefficient cuts would goad both parties into a grand bargain on fiscal policy. Despite consensus within Washington that the sequester was a stupid way of cutting the budget, no bargain ever materialized. Instead, partisan deadlock allowed the sequester to occur in March 2013.

  Whatever lessons politicians learned from the 2011 debt showdown had been unlearned by fall 2013. The government was shut down for the first time in nearly twenty years, and the United States again came perilously close to defaulting on its obligations because of a failure to raise the debt ceiling. The final deal preserved the sequester as a mechanism for restraining government spending. Public- and private-sector analysts estimated that the shutdown shaved between 0.2 and 0.6 percent of growth off fourth-quarter GDP in the United States.60

  The most optimistic assessment of the US macroeconomic policy response to the Great Recession is that it was better than that of other developed economies.61 Other assessments have been somewhat more downcast. Macroeconomic Advisers estimates that the combined effect of fiscal drag and policy uncertainty between 2010 and 2013 slowed
annual GDP growth by up to 1 percent and raised the unemployment rate by 0.8 percent, or approximately 1.2 million jobs.62 Not surprisingly, the political paralysis over the debt ceiling and fiscal policy accelerated the decline in public trust in government. Both Gallup and Pew data showed a marked decrease in the trust in the federal government to do the right thing.63 Norman Ornstein and Thomas Mann concluded, “We have been studying Washington politics and Congress for more than 40 years, and never have we seen them this dysfunctional.”64

  Europe’s situation is more complex because of the sui generis nature of the eurozone. International relations scholars are often unsure about whether the European Union is an example of global governance or a proto-state. And to be sure, the Great Recession was the trigger for the eurozone’s sovereign debt crisis. The international response to the crisis has been that of a modest supporting role. The IMF proffered both its technical expertise and financial support in excess of $100 billion to Greece, Portugal, and Ireland. The United States and other major economies reopened swap lines with the European Central Bank to ensure liquidity.65 European and national policy responses to the crisis, however, badly exacerbated the economic situation. Greece’s reckless pre-crisis government spending and borrowing made that economy a ripe target for market pessimism. European officials allowed Greece’s sovereign debt crisis to fester, ratcheting up the costs of any intervention. As the crisis worsened, the initial proposal in conversations for a rescue fund among European officials was only 60 billion, woefully inadequate to address Greece’s deteriorating debt dynamics.66 As is discussed further in chapter 6, the austerity policies advocated in some quarters have not panned out as expected.67 Austerity-related policies led to a double-dip recession in Great Britain, higher borrowing costs in Spain and Italy, and continued uncertainty about the euro’s future. The European Central Bank’s decision to raise interest rates prematurely in 2010 stalled any nascent recovery on the continent. Europe’s fiscal and monetary policies were far less expansionary than those in the United States. This, in turn, prevented any appreciable private sector deleveraging in Europe, thereby guaranteeing a longer downturn before any sustained recovery was possible.68

  The IMF came under criticism for failing to exert more influence over the eurozone crisis. One high-ranking staffer resigned in June 2012, blasting the fund for its “European bias” and consensus culture that keep it from criticizing countries in the middle of lending programs.69 There are two counterpoints to this argument, however. First, the IMF was critical at various moments during the eurozone crisis. IMF staff issued warnings about the health of the European banks in August 2011, and Managing Director Christine Lagarde called for debt sharing among the eurozone countries in June 2012.70 The first criticism received significant pushback from the European Central Bank and the eurozone governments, and Germany ignored the second criticism. This leads to the second point: it is highly unlikely that national governments would feel compelled to respond to IMF criticism in the absence of a market response.71 The fund always walks a tight-rope between transparent criticism and setting off market panic. This is hardly an ideal position from which to strong-arm governments with sizable IMF quotas.

  The policy responses of Japan, the United States, and the eurozone economies were widely variable. Most of their macroeconomic policy errors, however, had little or nothing to do with foreign economic policy or adherence to global governance strictures. In each case, it was domestic institutions and beliefs that led to suboptimal responses—which in turn caused a decline in the public trust of national governments. This highlights a vicious cycle in Great Recession politics that makes cooperation at the international level even more remarkable. The financial crisis led to negative economic outcomes, which in turn triggered increased vulnerability and instability for incumbent governments.72 Unpopular and short-term governments are far less likely to stress the need to cooperate at the global level. The perception of failed global governance might be a way of venting about national-level failures. Indeed, domestic-policy elites had an incentive to scapegoat global governance as a way to divert populist anger. In a world where elected officials in the United States, Europe, and Japan were politically weak and tempted to redirect anger at unelected multilateral institutions, it is extraordinary that global governance worked as well as it did.

  No matter how globalized the economy becomes, the center of gravity for the provision of public goods will remain at the national and local levels. It is possible, however, for national and local governance to be impaired while global governance structures accomplish their tasks. This reflects a fundamental truth about the global political economy: international economic institutions have a greater capacity to do harm than good. If global economic governance does not disrupt the functioning of the global economy during boom times, and cushions the worst effect of busts, then it has “worked.” On the whole, the great powers are sufficiently large for domestic policy to matter far more than global economic governance. Or, as Uri Dadush and Vera Eidelman phrased it: “The rules of the game do not need a big change; rather, the big players need to raise their game.”73

  Conclusion

  Chapter 2 demonstrated that the system of global economic governance performed admirably in the wake of the 2008 financial crisis. Despite that fact, there is a powerful perception among both elites and the public that the system did not work. What explains this cognitive dissonance? This chapter has explored the origins and possible causes of this misperception. There are four possible explanations. First, many commentators extrapolated from a few high-profile failures in global economic governance a conclusion that the entire system was dysfunctional. The kerfuffles over currency wars further revealed a gap in understanding between political commentators and global political economy scholars.

  Second, many commentators made the default assumption that global economic governance was better in the past. In point of fact, such governance was haphazard at best. For much of the previous two centuries, the great powers failed to agree or to adhere to agreements on the open global economy. In some instances, there was an agreement to coordinate policy—but that agreement had catastrophic economic effects. Compared to the past, the post-2008 global economic governance has been plenty “good enough.”

  Third, the distribution of economic growth since the start of the Great Recession does not track the distribution of commentary about global economic governance. Global political and economic analysis remains anchored in the West; yet the biggest beneficiaries of post-2008 global economic growth are located elsewhere. Western analysts might extrapolate from their national circumstances an assessment that global governance perfomed poorly or not at all. Not surprisingly, the areas in which the global economy has done better also show more optimism about the current situation.

  Similarly, commentators often conflate global governance and national governance. It would be hard to dispute that Japan, the United States, and the European Union have experienced high levels of political dysfunction since 2008. The weakening of political incumbents has undoubtedly contributed to a series of macroeconomic policy miscues, particularly after 2010. These miscues have, in turn, depressed aggregate economic output in these countries. With the partial exception of the eurozone, however, these mistakes are not a failure of global economic governance but rather of domestic institutions and beliefs.

  The fourth reason so many commentators have bemoaned the state of global economic governance lies in international relations theory. It seemed logical to expect that the system would not work terribly well. As previously noted, global governance was dysfunctional in the run-up to the 2008 financial crisis. Furthermore, a divergence of interests, shift in the distribution of power, and breakdown of hegemonic ideas seemed to be taking place. All these factors suggested that in the face of a crisis, the system would not work. And yet, counterintuitively, it did. The next three chapters look at the role that interest, power, and ideas played in ensuring that outcome.

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  The Role of Interest

  THE STORY SO FAR is simple: despite widespread ex ante fears and ex post perceptions to the contrary, the system worked after the 2008 financial crisis. Economic openness was maintained, providing the global public goods necessary to jump-start the economy. There had been, however, excellent reasons to believe that politicians would advocate a shift toward autarky once the crisis began. The pre-crisis observations about sclerotic international institutions and a looming power transition also did not seem too far off the mark. How did these institutions manage to produce the necessary policy outputs and reforms to stave off another worldwide depression? To answer the why, we need to look at causes. The meat and potatoes concepts of international relations are interest, power, and ideas. This chapter looks at the role played by interest groups to see if they were the reason the open global economy persisted, when, at first glance, one would have expected the opposite.

  The Great Recession created “hard times” for almost every government in the world.1 Such deep or prolonged economic downturns can undercut preferences for global economic openness in three ways. First, public support for trade protectionism and economic nationalism usually rises during significant recessions.2 Even if functioning global governance yields positive outcomes, there may be an increase in the proportion of the public that fears the sovereignty loss brought about by continued openness. Historically, protectionism has increased in economies experiencing prolonged slowdowns.3