The System Worked_How the World Stopped Another Great Depression Page 10

  Second, the longer a downturn persists, the more all actors will focus on the distributional effects of any global bargain. The standard argument in favor of economic openness is that cooperation at the global level produces win-win outcomes. The longer a low-growth period lasts, the less positive-sum agreements will be seen through a strict lens of absolute gain. Actors will start to think that driving a harder distributional bargain is the best way to maximize their national welfare.

  Third, hard times increase the barriers to exit for concentrated interests. As Albert Hirschman observed, actors can utilize market exit or political voice when confronted with unfavorable policy conditions, and they tend to specialize in one or the other over time.4 Immobile factors or sectors—which cannot move easily across sectors or borders—will concentrate on the use of political voice, because for them, the barriers to exiting the market are higher.5 During a downturn, however, it is difficult for even mobile factors of production to craft a viable exit option. When market exit is blocked, more actors turn to political voice as a means of getting what they want from national government. Voice options carry greater political and economic costs for governments trying to comply with global governance arrangements. The more actors exercise political voice, the greater the adjustment costs for any country attempting global policy coordination. Governments feel more political pressure to cater to the demands of entrenched interests.

  Previous eras of hard times demonstrate the difficulty of sustaining viable international economic regimes during downturns. The global economic upheavals of the 1930s and 1970s, for example, also led to demands for global governance reform, but multilateral efforts foundered because of negative domestic political feedback. The volatility and uncertainty of the thirties and seventies triggered national-policy shifts that changed the global economic order. The onerous demands placed on domestic markets to adjust to the gold exchange standard in the interwar period led social movements in most of Europe to push back against it.6 In the United States, stagflation in the 1970s led to strong popular support for more hawkish anti-inflationary policies, the political management of exchange rates, and the deregulation of financial markets.7 These policy shifts were not embraced by other great powers, leading to clashes at the global level.

  So there were excellent reasons to expect that, in response to the Great Recession, none of the great powers would be terribly interested in sustaining an open global economic order. And yet, the purpose behind most post-2008 great-power actions was to reinforce existing global economic governance structures. The result was a system of rules that kept a firm bias toward economic openness, while tweaking some aspects of regulation at the margins. What explains these policy preferences?

  In looking at the role material interests played in the calculations of the great powers during the crisis, this chapter asks the question Did interest groups “capture” great-power governments and push them to make the system work—and if so, why? It briefly reviews how global political economy scholars think about interest-based explanations and discusses why those theories do in fact predict sustained levels of economic openness, particularly in the capital account. It then focuses on the negotiations surrounding the creation of the Basel III banking accord. This case provides an easy test of theories that predict the capture of national interests by powerful economic sectors. Basel III, however, suggests that there are hard limits to theories rooted in sectoral interests.

  Material Interests and Global Political Economy 101

  As previously noted, the resilience of a functioning, open global economy was a surprise to many after 2008. Politics 101 suggested that the downturn should have led to an upsurge in scapegoating the international economy, calls for protectionism, and a push toward more autarky in the name of “resilience.” Punditry 101 also suggested a problem resulting from the perceived power transition taking place between the United States and China. The financial crisis was expected to accelerate this transition, amplifying uncertainty in the global economy.

  Global Political Economy 101, however, offers a different take. The degree of interdependence among the key actors in the current era of globalization gave powerful interests a strong stake in maintaining a functioning, open global economy.8 As John Ikenberry observes, “The complex interdependence that is unleashed in an open and loosely rule-based order generates expanding realms of exchange and investment that result in a growing array of firms, interest groups, and other sorts of political stakeholders who seek to preserve the stability and openness of the system.”9

  The dominant way of thinking about the global political economy for the past two decades has been the open economy politics (OEP) paradigm, which is a two-step model for determining interests and outcomes. The first step centers on how material interests and domestic institutions shape foreign economic policies. After mapping policy preferences from the position of powerful sectors in the domestic economy and looking at how domestic institutions aggregate those preferences, OEP moves to the next step, analyzing how the constellation of different foreign economic policies combines into global policy outcomes. David Lake accurately summarizes OEP as follows:10

  OEP begins with individuals, sectors, or factors of production as the units of analysis and derives their interests over economic policy from each unit’s position within the international economy. It conceives of domestic political institutions as mechanisms that aggregate interests (with more or less bias) and structure the bargaining of competing societal groups. Finally, it introduces, when necessary, bargaining between states with different interests. Analysis within OEP proceeds from the most micro- to the most macro-level in a linear and orderly fashion, reflecting an implicit uni-directional conception of politics as flowing up from individuals to interstate bargaining.

  In other words, OEP privileges domestic interests as the sources of preferences and constraints on national policies and essentially “brackets” everything else.11 These interests inform, influence, and capture national and international policymaking structures.

  OEP can offer a parsimonious narrative about why the system worked after the 2008 crisis. It argues that powerful interests across the major economies had a deep stake in the continued process of globalization. Production, trade, and finance in the twenty-first century are so globalized that they inculcate truly transnational interests. Developments like the global supply chain, “just in time” delivery systems in merchandise trade, repo markets, and the carry trade imbricate national economies into the international system. The interests that earn the most concentrated profits from these global production regimes then capture key policymaking institutions, causing them to take necessary actions at the national and global levels so as not to interfere with the global supply chain.

  To understand the extent to which the global economy is truly integrated, consider the extent to which the manufacture of the Apple iPod and successive products enmesh different countries. Apple introduced the iPod in October 2001. Over the next decade, it triggered a wave of new gadgets and apps from Apple and other firms, including smartphones, tablet computers, and cloud computing. Since Apple is headquartered in the United States, it would be natural to presume that the iPod and iPhone represent an American success story. Gadget enthusiasts are no doubt aware that the answer is more complex. Although the iPhone was invented in America, it is assembled in China. According to economists Yuqing Xing and Neal Detert, the iPhone alone contributed $1.9 billion to the US trade deficit with China in 2009.12

  But the globalization of twenty-first century production is even more complicated than that. If you break down who produces the component parts of the iPhone, the picture changes. While China plays a major role in the final assembly of the iPhone, it plays a minor role in the creation of its value added. The iPhone’s flash drive comes from Toshiba—a Japanese firm. The South Korean firm Samsung provides the application processor. The German company Infineon provides the camera module. An American corporation provides the Bluetooth ap
plication. All of these parts are assembled by a Taiwanese firm, Foxconn, with operations in Shenzen, China. The People’s Republic of China is responsible for less than 4 percent of the total value added of the iPhone.13

  The OECD and WTO jointly produced a data set on “trade in value-added” in 2013 to clarify how the global supply chain affects cross-border exchange.14 Their preliminary results demonstrate that the simple dichotomy of export interests and import interests has broken down in major sectors of the global economy. For example, in the transport goods market, between one-third and one-half of the total value added of national exports comes from intermediate-good imports. A similar amount emerges in the electronic goods sector. Indeed, for most of the OECD economies, approximately one-third of all intermediate-goods imports are intended for finished goods that are then exported. This fraction of value-added imports rises to over 50 percent for Pacific Rim exporters. The global economy, as it is currently constituted, makes even the most prolific exporting countries dependent on imports from the same sector in order to maintain a functioning economy. Any individual national node in a global value chain needs access to efficient imports of goods and services in order to stay globally competitive.

  One can tell a similar story in the financial realm. By 2008, the complex interdependencies of global finance were such that most significant financial institutions were engaged in extensive overseas operations. The “home bias” of institutional investors ebbed considerably in the ten years before the Great Recession.15 Financial innovations accelerated the cross-border spread of capital. The “carry trade” allowed money-market-fund managers to take assets from one country and make overnight deposits into other countries with higher interest rates, turning places like Iceland into temporary financial hubs. Repurchase, or “repo,” markets, permitted financial institutions to give each other massive short-term credit.16 By 2006, gross cross-border flows in both the United States and the United Kingdom had expanded to more than five times GDP.17 The reason the collapse of Lehman Brothers proved so disastrous is that it exposed the complex interdependencies and tight coupling within the financial sector.18 One would therefore expect each national financial sector to fight vigorously against any move toward capital controls or regulatory stringency.

  The political effect of global supply chains and imbricated capital markets is to harmonize the interests of the trading sectors of the major economies. While competition among individual suppliers may be powerful, the effect of global integration is even more powerful. Crude protectionism is therefore a useless gesture, even during hard times. Policy preferences over matters such as exchange rates wane as specialization increases.19 And in the absence of powerful interest groups lobbying for greater closure, the OEP paradigm would predict minimal steps toward closure, even in response to the crisis.

  OEP is not the only international political economy approach that arrives at this prediction. Whereas OEP starts with economic interests and then moves to the aggregation of those interests, historical institutionalism emphasizes the feedback mechanisms that build up between institutions and interest groups.20 As Henry Farrell and Abraham Newman explain, historical institutionalism stresses “the propensity of state institutional reforms to create client groups that then have a strong incentive to push for their maintenance.” In any temporal process of interest formation, policy feedback and path dependence shape the contours of future public policy.21 The logic is as follows: at time t, a set of rules is codified for actors based in a particular economic sector. These rules help to shape and reinforce the preferences of the salient actors, weeding out firms and workers incompatible with those rules and bolstering actors who are compatible. At time t + 1, the cost of switching away from the status quo is somewhat higher for the remaining actors, so they lobby harder to make sure the status quo stays the same. With each interaction, the reinforcement between actor preferences and the rules of the game that bind them make it increasingly unlikely that the status quo will be changed endogenously. Political institutions shape the preferences of interest groups, and this in turn reinforces the stability of the original set of policy preferences.22

  For this paradigm, the predominant fact of life in the pre-2008 global political economy was the twenty-year persistence of capital-account liberalization and deregulation.23 Because these policies diffused widely and deeply, the market should have winnowed or weakened any financial actors that could not survive the openness of economic globalization. Furthermore, those remaining actors would have exerted even more pressure on government institutions to enforce status quo policies. This can be seen most clearly in the evolution of financial regulation in the United States. In the decades before the Great Recession, the financial sector resisted all efforts at regulation and pushed for deregulation at every opportunity. As a result, the 1933 Glass-Steagall Act was repealed in 1998, allowing investment banks to acquire commercial banks, and vice versa. Banks lobbied fiercely to switch capital-adequacy standards from a simple reserve ratio (Basel I) to more flexible standards (Basel II). Key sectors of the financial sector were left essentially unregulated. Despite efforts by the SEC to enact regulaton in these areas, for example, Congress expressly forbade the commission from regulating derivatives markets. Private-equity firms and hedge funds were also left untouched. The complex revolving door between regulators and private-sector financial firms only reinforced this set of policy preferences.

  Each of these policy moves caused the financial sector to grow wealthier and more powerful. Finance went from comprising 2.5 percent of US GDP in 1947 to being 7.7 percent of GDP in 2005.24 And at the peak of the housing bubble in 2006, the financial sector comprised 40 percent of all the earnings of the Standard & Poor’s 500. The incomes of the country’s twenty-five top hedge-fund managers exceeded the total income of all the CEOs of firms in the S&P 500.25 As Andrew Baker noted, “Regulatory capture was in part a natural outcome of the ‘financialization’ of Anglo-American society and the sheer size of the financial sector.”26 With the United States having this kind of clout, it is no wonder that former IMF chief economist Simon Johnson described it as akin to a kleptocratic third world state.27 Furthermore, the growth of the financial sector in the United States was matched by similar rates of growth in Great Britain, Canada, Australia, and other Anglosphere economies.28 It would not be surprising, then, if these other economies also developed finance-friendly institutions and regulations.

  So, according to Global Political Economy 101, powerful and shared interests drove the functioning of global economic governance during the Great Recession. Despite the 2008 crisis, entrenched private-sector groups across powerful economies had a vested interest in maintaining the openness of the global economy. Whether one relies on OEP or historical institutionalism, the strength and homogeneity of the private sector’s preference to maintain an open global economy were overwhelming. The rise of global supply chains meant that export sectors would lobby for lower levels of import protection at home as well as abroad. The concentration of global financial firms meant that the financial sector would lobby national and international actors, pushing strenuously for limiting financial regulation and promoting open capital accounts. These interests captured powerful state institutions, which, in turn, were able to motivate global economic governance into doing what was necessary to maintain economic openness.

  There is prima facie evidence to support this argument, particularly in trade policy. One World Bank study examined trade restrictions since 2008 and found “vertical specialization” to be the most powerful economic factor determining post-crisis tariff rates. The more a country’s economy was enmeshed in the global supply chain, the less likely it was to raise tariffs.29 Other studies have demonstrated that the major trading states refrained from raising import barriers to stagnating trade partners, even when such actions were permissible under WTO rules.30 This suggests that governments refrained from protectionist actions for reasons that go beyond international institutional constraints. Si
milarly, an examination of the relationship between a G20 member’s exposure to the global economy and its compliance with G20 commitments supports this argument. Comparing pre-crisis country scores from the Swiss Economic Institute’s the KOF globalization index with the University of Toronto’s G20 monitor scores shows that greater ex ante exposure to globalization is positively correlated with compliance with global economic governance.31 In other words, the economies most dependent on the global economy before the Great Recession were also the most cooperative after the financial crisis began.

  The Ideal Test of Basel III

  An excellent test of the power of material interests in the wake of the 2008 financial crisis comes from an examination of the Basel III banking accord. One of the big post-2008 questions was how global banking regulations should be reformed to prevent a crisis of its magnitude from occurring again. The existing international standard at the start of the subprime mortgage crisis, articulated by the Basel Committee on Banking Supervision (BCBS), was the Basel II accord. To be sure, the expert consensus was that Basel II was not one of the primary causes of the failures of the global financial system.32 As the crisis unfolded, however, there was a growing appreciation that the Basel II accord had contributed to the procyclical nature of bank lending during the pre-crisis years.33 Basel II gave banks the option of relying on internal models to assess their balance sheets. The 2008 crisis revealed those value-at-risk models to be badly flawed.34 Banks overestimated the value of their assets because of their inflated value during the bubble years. This permitted banks to increase their loan portfolios and engage in even riskier investment practices. This cycle simultaneously fueled the subprime mortgage bubble and left financial institutions badly overextended when the crisis hit. European banks were woefully undercapitalized when Lehman Brothers went bankrupt, and the markets for some of their assets dried up completely. This, in turn, highlighted another flaw of Basel II: a failure to require banks to hold liquid forms of capital. Without higher liquidity levels, banks were unable to function properly during credit crunches. Even before the acute phase of the crisis, the Financial Stability Forum blasted the “significant weaknesses” of existing banking standards, concluding that “further improvements to Basel II and strengthened supervisory liquidity guidelines are needed.”35