Political Foundations of the World Economy International Political Economy Prof. Tyson Roberts 1

Lecture Goals States & Markets in International Context Bilateral and Multilateral Global Institutions Brief History of the World, IPE style 2

If R obinson lives alone, he does everything himself 3

If a second person arrives, one can specialize in coconuts and the other can specialize in fish, and they can benefit from trade 4

If each actor is “fully informed,” trade results in a Pareto Improvement 5 Friday Don’t tradeTrade Robinson Don’t trade0, 0 Trade0, 01, 1

However, each actor may have an incentive to cheat 6 Friday CheatStay true Robinson Cheat-1, -12, -2 Stay true-2, 21, 1

Cheat, Cheat is the Nash Equilibrium Stay true, Stay true would be Pareto Improvement 7 Friday CheatStay true Robinson Cheat-1, -12, -2 Stay true-2, 21, 1

Institutions to prevent cheating 1.Long-term relationships based on reciprocity and trust 8

The prospect of repeated interactions converts cooperation into a Nash Equilibrium (But Cheat, Cheat also remains a Nash Equilibrium) 9 Friday Cheat Stay true first trade; Cease trading if cheated Robinson Cheat-1, -12, -2 Stay true first trade; Cease trading if cheated -2, …, …

If the coconut seller gets a bad fish, he knows who sold it to him. He can refuse to trade again until he is compensated 10

As the distance and complexity of trade increases, potential for trade benefits increase… 11

As the distance and complexity of trade increases, potential for trade benefits increase, but cheating is more difficult to monitor 12

The challenge of long-distance trade Strong incentive to cheat, makes trade costly 13 Trader 2 CheatStay true Trader 1 Cheat-1, -12, -2 Stay true-2, 21, 1

Institutions to prevent cheating 1.Long-term relationships based on reciprocity and trust – Works best in smaller groups (repeated interactions, reputation) 14

Solutions to cooperation problem 1.Repeated transaction – Works within tight-knit communities (Jews, Lebanese, Hausa, etc.), but not among the world at large 2.Belief system/ideology (focal point) – Also works best in tight-knit communities 3.Third-party enforcement – E.g., by a imperial power or a hegemonic state 15

Cooperation solution in state of anarchy The repeated interaction cooperation solution depends on valuing the future QE 16

The Wire’s Baltimore: When Avon Barksdale is in charge Barksdale Fight for territoryDon’t fight Prop JoeFight for territory 2,24,1 Don’t fight 1,43,3 What is the expected outcome? (i.e., Nash Equilibrium) Is it Pareto Efficient?

The Wire: When Avon Barksdale is in charge Barksdale Fight for territoryDon’t fight Prop JoeFight for territory 2,22,24,1 Don’t fight 1,43,3

The Wire: When Stringer Bell is in charge Stringer Bell Fight for territoryShare territory in exchange for good product; attack if crossed Prop JoeFight for territory 2,24,1 Share good product in exchange for territory; withhold if crossed 1, = 5,5 What is the expected outcome? (i.e., Nash Equilibrium) Is it Pareto Efficient?

The Wire: When Stringer Bell is in charge Stringer Bell Fight for territoryShare territory in exchange for good product; attack if crossed Prop JoeFight for territory 2,22,24,1 Share good product in exchange for territory; withhold if crossed 1,45,55,5 Two (Pure strategy) Nash Equilibria: (1)PJ - Fight; SB - Fight (2)PJ - Share; SB - Share

Repeated interactions can but do not necessarily lead to cooperation Another mechanism is third party enforcement 21

State Building, Wars, and Markets Kings need resources to fight wars Taxing money is less costly than extracting tribute Money is mobile Solution: Property rights enforced by King 22

p is penalty for stealing. Assume p>1 Is enforcement by the State Freedom or a Prison? State of natureCivil society Enforced by State ForbearStealForbearSteal Forbear(3,3)(1,4)Forbear(3-t,3-t)(1-t,4-p-t) Steal(4,1)(2,2)Steal(4-p-t,1-t)(2-p-t,2-p-t) Indicates the NE in each game.

p is penalty for stealing. Assume p>1 Is enforcement by the State Freedom or a Prison? If p =2 & t= ½, is society better off with or without the state? State of natureCivil society Enforced by State ForbearStealForbearSteal Forbear(3,3)(1,4)Forbear(3-t,3-t)(1-t,4-p-t) Steal(4,1)(2,2)Steal(4-p-t,1-t)(2-p-t,2-p-t) Indicates the NE in each game.

Is enforcement by the State Freedom or a Prison? If p =2 & t= 1/2, is society better off with or without the state? WITH. STATE => FREEDOM State of natureCivil society Enforced by State ForbearStealForbearSteal Forbear(3,3)(1,4)Forbear(3-t,3-t) 2 ½, 2 ½ (1-t,4-p-t) ½, 1 ½ Steal(4,1)(2,2)Steal(4-p-t,1-t) 1 ½, ½ (2-p-t,2-p-t) -1/2, -1/2

p is penalty for stealing. Assume p>1 Is enforcement by the State Freedom or a Prison? If p =2 & t= 2, is society better off with or without the state? State of natureCivil society Enforced by State ForbearStealForbearSteal Forbear(3,3)(1,4)Forbear(3-t,3-t)(1-t,4-p-t) Steal(4,1)(2,2)Steal(4-p-t,1-t)(2-p-t,2-p-t) Indicates the NE in each game.

Is enforcement by the State Freedom or a Prison? If p =2 & t= 2, is society better off with or without the state? WITHOUT. STATE => PRISON State of natureCivil society Enforced by State ForbearStealForbearSteal Forbear(3,3)(1,4)Forbear(3-t,3-t) 1, 1 (1-t,4-p-t) -1, 0 Steal(4,1)(2,2)Steal(4-p-t,1-t) 0, -1 (2-p-t,2-p-t) -2, -2

p is penalty for stealing. Assume p>1 Is enforcement by the State Freedom or a Prison? If the state does not charge too much tax (3-t > 2, or 1 > t), life will be better in civil society. State of natureCivil society Enforced by State ForbearStealForbearSteal Forbear(3,3)(1,4)Forbear(3-t,3-t)(1-t,4-p-t) Steal(4,1)(2,2)Steal(4-p-t,1-t)(2-p-t,2-p-t) Indicates the NE in each game.

A third mechanism to facilitate trade is ideology (focal point) 29

Institutions to prevent cheating 1.Long-term relationships based on reciprocity and trust – Works best in smaller groups (repeated interactions, reputation) 2.Belief systems 3.Third party enforcement 30

History of the World, IPE-style: Unilateral Institutions & Mercantilist Beliefs ~1600-~1850: Mercantilism – Trade facilitated by empires & chartered trading companies within empires 31

History of the World, IPE-style: Unilateral Institutions & Liberal Beliefs ~ : 1 st Age of Globalization – Common belief system among key economic decision-makers: market liberalism (Smith, Ricardo) & rules of Gold Standard – Enforcement by imperial governments, esp. Britain 32

Large, leading economies gain most from free trade 33

State Power and the Promotion of National Interests through Economic Integration Powerful states with leading economies have strong interest in promoting an open world economy – UK in 19 th Century – US in 20 th Century Economic integration creates markets & reduces cost of maintaining world order 34

Neorealism (Waltz) – ‘in a condition of anarchy, relative gain is more important than absolute gain’ – emphasizes the weakness of international institutions and the fragility of cooperation 35

What is the difference between relative gain and absolute gain? Should states focus on relative or absolute gain? Why are actors focused on relative gain less likely to cooperate? 36

Payoffs with absolute gain Challenger Reduce tariffsHigh tariffs HegemonReduce tariffs 8, 64, 4 High tariffs 6, 22, 1 What is expected outcome? (i.e., Nash Equilibrium) 37

Payoffs with absolute payoffs Challenger Reduce tariffsHigh tariffs HegemonReduce tariffs 8, 64, 4 High tariffs 6, 22, 1 What is expected outcome? (i.e., Nash Equilibrium) 38

Now transform the outcomes in each cell from absolute payoffs to relative payoffs For example, my relative payoff is my payoff/your payoff. 39

Payoffs with relative payoffs Challenger Reduce tariffsHigh tariffs HegemonReduce tariffsHeg. 8/6 = 4/3 Chall. 6/8 = 3/4 Heg. 4/4 = 1 Chall. 4/4 = 1 High tariffsHeg. 6/2 = 3 Chall. 2/6 = 1/3 Heg. 2/1 = 2 Chall. 1/2 = ½ What is expected outcome? (i.e., Nash Equilibrium) 40

Payoffs with relative payoffs Challenger Reduce tariffsHigh tariffs HegemonReduce tariffs 4/3, 3/41, 1 High tariffs 3, 1/32, 1/2 What is expected outcome? (i.e., Nash Equilibrium) 41

Neoliberal institutionalism (Keohane, etc.) – Institutions are solutions to interstate problems such as cheating – Institutions are agreements or contracts between actors that reduce uncertainty, lower transaction costs, and solve collective action problems 42

International regimes can affect – Capabilities of states – Interests of states 43

International regimes can affect capabilities of states Dependency theory (e.g., Marxist): regimes reinforce dominance of rich, powerful states Hegemonic stability theory: international regimes enrich hegemon (but over time may dissipate hegemon’s resources) Why? 44

Large, leading economies gain most (in absolute terms) from free trade 45

Hegemon gains most from free trade regime & can afford to maintain Challenger also benefits, but is less able to afford maintenance 46 Challenger Spend to maintain regime Don’t spend HegemonSpend to maintain regime8, 35, 4 Don’t spend 6, 12, 2

Challenger can therefore free-ride on hegemon’s efforts 47 Challenger Spend to maintain regime Don’t spend HegemonSpend to maintain regime8, 35, 4 Don’t spend 6, 12, 2

World GDP per capita 1 st Era of Globalization 48 Source: Angus Maddison

Without a hegemon, no country can capture benefits of free trade regime enough to make maintenance of free trade regime worthwhile => lack of cooperation 49

History of the World, IPE-style: Breakdown of free trade regime World Wars: (Breakdown, Trade barriers go back up) – : WW1 – : Interwar period & WW2 – : WW2 50

History of the World, IPE-style: Return of free trade; new hegemon supports multilateral institutions 1945-present: 2 nd Age of Globalization Enforcement by US & Bretton Woods Institutions – : Bretton Woods System 1944, 1947: IMF & GATT established Belief system: Keynes, etc. – : Transition & Washington Consensus 1995: WTO established Belief system: Chicago School 51

International Decision-Making Rules Anarchic – Unilateral or negotiated decisions based on self interest and power. – Lack of cooperation => War Hegemonic Institution(s) – Hegemon’s law backed by power (empire, gunboats) Multilateral Institution (official) – Majoritarian – Weighted voting – Consensus Multilateral institution (unofficial) – Invisible weighting/ informal agenda setting

Scope of GATT Trade in most manufactured goods liberalized quickly – Exceptions: Clothes, textiles, some cars, etc. Services & agriculture initially left alone Focus on tariffs and trade quota Developing countries given waivers or extra time to comply GATT had weak enforcement teeth

GATT decision making rules Officially: majoritarian Unofficially: Informal consensus – Launching rounds: law-based bargaining – Closing rounds: increased power-based bargaining

Sources of bargaining power Patience – Willingness to live with status quo Outside option – Related to market size (US can produce for self) & international relations Agenda setting – Access to “Green Room” Ability to act collectively – OECD, G-20

Organized Hypocrisy Consensus in the GATT/WTO Naked power available as alternative Consensus rules provide legitimacy and information gathering to powerful nations – stable, low cost method to achieve goals Some votes bought with pay-offs Weaker nations unlikely to protest openly if hypocrisy not too blatant Multiparty elections in authoritarian regimes Naked power available as alternative Multiparty elections provide legitimacy & information gathering to ruling elites – stable, low cost method to achieve goals Some votes bought with pay-offs Opposition unlikely to protest openly if hypocrisy not too blatant

Bargaining in the Shadow of Law or Power (Steinberg 2002) The Tokyo Round ( ) closed with law- based bargaining LDC’s outside option: Trade with Soviet Bloc Result: Exceptions for LDCs Uruguay Round ( ) closed with power- based bargaining No outside option for LDCs Result – uniform rules in WTO

Scope of WTO Liberalization of all goods (including textiles & agriculture) and services Rules extended to subsidies, intellectual property, investment, regulations & standards All members (including developing countries) bound to comply Enforcement teeth: appellate court to decide disputes – authorizes dispute winner to retaliate

Cotton Wars Does the cotton dispute indicate law-based or power-based decision making? Does the cotton dispute indicate that international regimes change outcomes? How do sub-national interest group politics play a role in determining the outcome?

GATT/WTO Benefits – Worldwide (2 nd Age of Globalization) 60 Source: PWT for countries w/1950 data only; not sure about Maddison BW Post-BW

GATT/WTO Benefits - Distribution International: – According to some studies, developed countries benefited more from WTO (Uruguay Round) than developing countries – According to some studies, some developing countries are net losers from WTO (diminished development policy space) – Other developing countries are winners, e.g. China and India

GATT/WTO Benefits - Distribution Intranational: – Trade integration has contributed to income inequality in the US (but technological change likely played a larger role) – Inequality has also increased in China and India – Low-skilled workers in labor-intensive manufacturing sectors were first losers in US; higher skilled workers in services may follow

Takeaways All countries can benefit from free trade Within countries, there are winners and losers Domestically, potential losers from free trade (e.g., producers) can solve collective action problem, which enables successful lobbying Institutions such as WTO facilitate cooperation for mutual benefit (at the country level) WTO increases role of law, but power still plays a role (e.g., availability of outside options) – Some countries may be net losers from WTO

International regimes can affect – Capabilities of states Hegemon gains in absolute terms, but challengers able to catch up – Interests of states Winners from trade gain political influence & press for more free trade (Corn Laws, etc.) As interdependence decreases probability of conflict, governments focus more on absolute gain & less on relative gain 64

Challenges in studying regime effects on cooperation Difficult to ascertain whether cooperation is due to institutions or to complementary interests & underlying distributions of power – A solution: if actors obey rules that are “inconvenient”, then institutions matter 65

The EU What are the benefits to strong states (e.g., Germany)? What are the benefits to weak states (e.g., Greece)? What are the costs? What choices by Germany and Greece demonstrate that institutions affect the decisions of sovereign states? 66

Takeaways International trade, lending, and investment is costly and risky in state of anarchy Enforcement institutions facilitate trade and lending/investment Enforcement institutions can be unilateral (predominant pre-WWI) or multilateral (predominant post-WW2). Institutions that constrain have costs and benefits for all, including the great powers 67

Takeaways Even if everyone wins in absolute terms, there are relative winners and losers, within and across countries Hegemonic stability theory: the hegemon is a relative winner at first, but becomes a relative loser as the challenger benefits from freeriding 68