Globalization, Trade, and International Political Economy^[1]

By Rom, Mark, Hidaka, Masaki, & Bzostek Walker, Rachel

Reused from Chapter 16 of Rom, Mark, Hidaka, Masaki, & Bzostek Walker, Rachel. (2022). Introduction to Political Science. OpenStax. https://openstax.org/details/books/introduction-political-science under CC-BY 4.0 license. Access for free at https://openstax.org

Figure 4.1 US Secretary of Agriculture Tom Vilsack and leaders from across the globe discuss public-private investment and cross-sector partnerships in a climate-smart agriculture and food system at the COP26 in Glasgow, Scotland, on November 4, 2021. (credit: “20212204-OSEC-UNC-0006” by U.S. Department of Agriculture/Flickr, Public Domain)

Introduction

The 26th UN Climate Change Conference of the Parties (COP26) occurred in Glasgow, Scotland, in October and November 2021. The main goal of the summit was to foster collaboration between governments, businesses, and civil society and to propel action to tackle the climate crisis.¹

The conference was widely reported in both traditional media and nontraditional media. As discussed in Chapter 12: The Media, traditional media is characterized by mass communication efforts and professional journalism. The main traditional media outlets include newspapers, magazines, radio, and television. With increased use of the internet, smartphones, and social media platforms, nontraditional media has become increasingly powerful. Whereas professional journalists cover the news for traditional media outlets, nontraditional news coverage may be led by any individual with a smartphone and internet access. Nontraditional outlets, such as Twitter, Facebook, Instagram, and TikTok, are particularly salient with specific niches of the public. That the results of the COP26 were reported on in traditional outlets like CNN, the Associated Press, the BBC, and Al Jazeera as well as nontraditional outlets like TikTok, Twitter, Instagram (more than 318,000 posts are tagged #cop26),² and Facebook (more than 160,000 people have posted using the hashtag #COP26) suggests that the public is concerned with the environment.³

The COP26 summit produced an official agreement, and governments pledged to commit to adaptation, mitigation, and conservation efforts on methane, coal, transportation, and deforestation. These pledges could help the world prevent global warming from exceeding 1.5°C above preindustrial levels, a goal the majority of climate scientists involved with the COP26 consider challenging but possible.⁴

While some governments have agreed to tackle the climate crisis, others have avoided making any commitments. Governments play the “commitment vs. avoidance game” because environmental policy, like every other kind of public policy, requires costs to achieve benefits.

For example, certain types of environmental regulations—the body of taxes and tariffs, quotas, subsidies, and regulations governments issue to promote environmental protection—increase the costs of industrial production. In a globalized economy, higher production costs make it more difficult for firms to sell their products in a competitive international market, especially if the regulations are adopted domestically but not internationally. In situations like this, a factory that cannot compete may be forced to close its doors, and if this happens, workers become unemployed⁵—that is, workers pay a high cost.

On the other hand, environmental regulations promote environmental quality. If a factory emits fewer pollutants, the quality of the surrounding environment increases. The community in the factory’s vicinity reaps the benefits of less pollution. Better environmental quality contributes to improved health conditions.

However, the causal impact of this environmental regulation in the promotion of a healthier environment is difficult to prove. The connection between the extent to which changes in pollutant emissions can improve or exacerbate the health of community members is complex. Many variables impact both environmental quality and the community’s health. To make things even more difficult, if you consider the market share of this factory in a country and compare it to the global market, the proportional environmental benefit of this environmental regulation may seem small.

Environmental regulations present a tradeoff: they promote environmental quality,⁶ but they may cause unemployment, at least in the short term. Environmental quality is a widespread benefit. The entire community profits from it, even if each element of the community profits only a little bit. On the other hand, unemployment is a localized cost, and unemployed workers lose a lot. As a result, labor unions, workers, and business parties commonly refer to environmental regulations as “job-killing regulations” and thus tend to oppose them.⁷ In short, because environmental policies redistribute economic costs and environmental benefits across different groups in society, they face strong opposition, even if, as responses to the COP26 indicate, the general public is concerned about the environment.⁸

Given the complexity of designing environmental policies, governments consider the redistribution of costs and benefits and play the “commitment vs. avoidance game” based on how much their constituents, or voters, stand to win or lose with environmental regulations.

The ways in which public policies redistribute costs and benefits across domestic and international actors are at the core of the study of international political economy (IPE). This chapter presents a panoramic view of the development of the field from the 16th century to the present. The discussion begins with a brief historical overview, which is then followed by an analysis of some of the most debated issues in the field.

4.1 The Origins of International Political Economy

Learning Outcomes

By the end of this section, you will be able to:

• Define international political economy (IPE).
• Describe mercantilism.
• Define wealth according to the mercantilist theory.

International political economy (IPE) is a vast field of study occupied with the investigation of political processes and their economic consequences, which have both domestic and international impacts. IPE describes and explains the extent to which politics and public policies define winners and losers among different groups in a society.⁹

Those components of politics and policy making in a country that result in specific public policies are referred to as political factors. These components can be domestic, such as the organization of the electoral system, how politicians interact to establish policies, and the level of economic and institutional development, among others. They can also be international, like, for example, the pressure toward globalization and trade liberalization since the 1990s. Domestic and international political factors compel politicians to establish certain public policies.

Public policies invariably promote wealth redistribution in societies. As mentioned above, these policies shift benefits and costs across different groups and thus establish winners and losers.¹⁰ The example of the “commitment vs. avoidance game” played during the COP26 summit illustrates how governments negotiate environmental issues with eyes on how the policies they establish will cater to their constituents and thus increase these politicians’ chances of remaining in power.¹¹

Yet, political factors are constantly changing, and as they change, policy makers redesign policies, redefining the winners and losers. Profound transformations occurred in Western Europe during the Enlightenment, paving the way for the current economic system in the United States—the market economy, or capitalism. Such transformations also prompted the establishment of political economy as the field dedicated to the study of the relationship between politics and the economy. Adam Smith (1723–1790), a Scottish political thinker and economist, was one of the first to examine the relationship between politics and the economy. Given the influence of his writings on the development of the field, he became known as the father of political economy.

Although political economy only emerged as a field of study in the late 19th century, politics and the economy were already interconnected in the real world. Political economy has been around for as long as politicians have been making decisions that favor some groups at the expense of others.

The changes in politics and the economy that occurred during the Enlightenment deeply altered political and economic practices domestically and internationally. The centralization of political power in the hands of the monarch in Western Europe during the 17th and 18th centuries, known as absolutism, illustrates the impact of these changes and how they laid the foundations for the market economy. During the absolutist era, the belief in divine providence—that God had chosen the monarch to govern—was widespread. Monarchs had absolute political power and made decisions with the aim of increasing that power. At the time, power and wealth were interchangeable concepts: power begot wealth and wealth begot power.

This environment provided fertile ground for mercantilism, the dominant economic system throughout the absolutist era. Mercantilism was based on capital accumulation, or the increase of wealth. Notice, however, that during the absolutist era, there were no paper currencies: no US dollars, Mexican pesos, or Euros. The currency was made of precious metals, gold and silver. The more gold and silver acquired, the wealthier—and more powerful—the monarch or the country.

Precious metals are naturally occurring elements and cannot be created (despite alchemists’ best efforts); thus, the amount of wealth in the world was considered finite. Because wealth was limited, wealth accumulation was a zero-sum game.¹² The fact that a monarch got some gold meant that others had lost it. Therefore, to preserve their wealth and power, monarchs not only took precious metals whenever they could but also fiercely protected the wealth in their possession.

As rumors about “new worlds” rich in gold and silver circulated in Western Europe in the 16th century, monarchs sponsored naval fleets to venture into unknown seas in search of riches. Several European ships ended up “discovering” land and colonizing Native peoples in the Americas as well as in Asia, Africa, and Oceania. As the “new worlds” were colonized, monarchs could extend their domain to the colonies. Taking advantage of their absolute power, they seized precious metals and increased their wealth.¹³ After all, power begot wealth.

Wealth also begot power. During the 16th, 17th, and 18th centuries, European armies were composed of mercenaries.¹⁴ In times of impending war, monarchs would hire soldiers to defend their countries. The more wealth a monarch possessed, the more soldiers they could afford, and thus the higher their chances were of winning the war and maintaining their power.¹⁵

Given that wealth was finite, monarchs sought to accumulate wealth, or capital, through protectionist policies, which safeguard the domestic economy against foreign competition through the establishment of trade barriers such as tariffs, subsidies, import quotas, and other restrictions on imports. The rationale behind protectionist policies is that as a country’s balance of trade, or the difference between the value of exports and imports in a given period, maintains a surplus, the country accumulates capital.

Protectionist policies limited trade across countries and thus suppressed any incentives for industrial innovation and market development. Economic activities during the absolutist era were extremely limited; agriculture, food production, and the production of consumer goods used rudimentary inputs and technology. Production output was basically for subsistence, and common people had very few possessions. Only the royal family and the aristocracy had access to the few goods available for consumption, while the majority of the population did not consume much.

Yet, the capital the monarchy and aristocracy accumulated during mercantilism made the Industrial Revolution possible. The Industrial Revolution promoted many significant changes at the end of the 18th century. These changes pressured monarchs to let go of protectionist policies in favor of trade liberalization, helped markets to flourish, and welcomed the participation of the individual in the economy.

4.2 The Advent of the Liberal Economy

Learning Outcomes

By the end of this section, you will be able to:

• Explain the origins of the market economy.
• Define wealth according to classical liberal theory.
• Describe Adam Smith’s argument regarding the three levels of analysis.

The Enlightenment and the Industrial Revolution marked the introduction of new concepts that fundamentally transformed European societies and the world. Enlightenment thinkers freed human beings from an unquestionable religiosity, superstitions, and social rigidity. Absolutism could no longer be defended on the basis of God’s will and divine providence. The ideas of anthropocentrism, or the argument that human beings are the most important component of the Universe; rationalism, which is the belief that reason rather than experience is the foundation of knowledge; and scientism, or the view that inductive methods of the natural sciences are the only source of genuine knowledge, prompted changes that culminated with the French Revolution and the Declaration of Independence of the Thirteen Colonies. Movements toward political democratization and economic development based on these ideas have since been diffused to the four corners of the world.

The Enlightenment period promoted the idea of civilization as opposed to savagery. Societies that reflected anthropocentrism, rationalism, and scientism were the first to reap the benefits of the Industrial Revolution, including the development of the market and social progress, and to embody the idea of civilization. These societies were initially located in Western Europe and were then propagated to the colonized world, accompanying the migration movement and the birth of industrialization. Societies based on traditional religion and superstition, where family relationships defined power and politics, were considered savage. In University of Denver emeritus professor David P. Levine’s words, “Civilization is an important concept in political economy. . . . Civilized society provides its members with opportunities not otherwise available; but it also confronts them with dangers.”¹⁶

One of these opportunities is wealth creation. Enlightenment thinkers rejected the mercantilist idea that wealth is finite, proposing that wealth could in fact be created. The concept of wealth had been transformed. As Levine puts it, “Producing wealth is a special sort of activity. It is one that employs some of our assets to produce commodities: goods and services valued in the market.”¹⁷

This change in the perception of what constituted wealth had an enormous impact on political economy. If wealth is understood as the extent to which the market values a good or service, and if the creativity and industriousness of the human mind is boundless, then wealth is infinite.

More than 200 years later, we still employ Enlightenment ideas about the concept of wealth. Adam Smith played an important role in defining our understanding of wealth creation, the functioning of the market, and the role of the government in a market-based society. His beliefs in science and in human beings’ inclination toward progress are key to his account of political economy. Adam Smith laid the foundation for liberalism, the dominant economic practice that persists today, in his classic work The Wealth of Nations (1776). He rejected mercantilism, suggesting that monarchy’s insistence on the balance of trade surplus through trade barriers would hurt the economy. According to Adam Smith, the best approach to the economy was a laissez-faire one, in other words, the free-market approach in which governments do not interfere in the market and let things take their own course.

Figure 4.2 As this 2019 advertisement in a Bulgarian airport bearing his image shows, Adam Smith is still closely associated with free market ideas. (credit: modification of work by “Adam Smith Spreads the Gospel” by summonedbyfells/Flickr, CC BY 2.0)

Adam Smith developed his argument in The Wealth of Nations using different levels of analysis. First, he focused on the individual level and argued that self-interested individuals, or in other words, individuals focused on advancing their personal interests, tend to make decisions that will maximize results to their own benefit. Thus, if governments guarantee individuals the freedom to produce and trade as they please, society will be better off in the long run.

His second level of analysis examined the state. Adam Smith argued that countries should dedicate themselves to the production of what they produce best, following their comparative advantages. For example, he argued that given France’s geographic characteristics and the developed skills and abilities of its people, France can produce better cheese and wine than, for example, Great Britain, and at a lower cost. Therefore, he argued, France should produce cheese and wine. On the other hand, given Great Britain’s geographic characteristics and traditions, the British can produce better quality wool than the French, and therefore Smith argued that the British should produce wool and not cheese and wine.

At the international level of analysis, Smith argued that if countries stick to their comparative advantages, international trade should allow individuals in different countries to have access to the best products at the lowest costs. This would eliminate the need for trade barriers and result in a system of free international trade. In this case, both the French and the British would get the best cheese, wine, and wool at the lowest cost.

Adam Smith’s assumption regarding the benefits of a laissez-faire economy has accompanied the mainstream understanding of political economy since the publication of The Wealth of Nations. According to Adam Smith, the accumulation of capital in preindustrial societies allowed for the emergence of the Industrial Revolution, which produced consumable goods for society and elevated the quality of life of industrialized nations.

The ideas promulgated by Adam Smith and other political economists slowly promoted trade liberalization in Europe. Britain moved toward free trade in the 1780s with the repeal of the Corn Laws, trade restrictions such as tariffs and quotas on imported corn and food. The Corn Laws intended to keep corn prices high and favor domestic producers of food.¹⁸ Several European states followed Britain’s move and similarly promoted trade liberalization. Nevertheless, Britain returned to protectionist policies during the Napoleonic Wars (1803–1815), a series of battles fought by the French Empire and its allies, led by Napoleon I, against several European countries that formed various coalitions. The costs of war are high, and as war expenses accumulated, the British government levied tariffs on imported goods to generate revenues and pay for the costs of war. The end of the Napoleonic Wars culminated with the Congress of Vienna (1814–1815), a peace conference to reconstruct European relations after the downfall of Napoleon I. The Congress of Vienna led to the Concert of Europe, a general consensus to promote equilibrium among the five great European powers (Austria, France, Prussia, Russia, and the United Kingdom). It prevented another war from breaking out in Europe from 1815 to 1914.

The Concert of Europe period saw the flourishing of trade liberalization. Moreover, improved technology and the advent of new players in the international commodities market increased competition, and domestic pressure in favor of protectionist policies led the recently unified Germany to defect from the free-trade regime and return to protectionism in the 1870s.

In general terms, international trade picked up from the late 19th century until World War I. After World War I, protectionist policies became the rule again until the end of World War II, when the bases of the current international financial system were established.

4.3 The Bretton Woods Institutions

Learning Outcomes

By the end of this section, you will be able to:

• Describe the context of the creation of the Bretton Woods Institutions.
• Explain the origins and missions of the IMF, World Bank, GATT, and WTO.

At the end of World War II, the United States had a huge surplus in the balance of trade. Exports of military equipment and consumer goods to the Allied powers grew the American economy toward a pronounced recovery from the Great Depression, a severe financial crisis sparked by the 1929 stock market crash in New York that led to bank closures and high unemployment. The US government was aware of its military capabilities and advantageous economic position, especially in relation to destroyed Europe and Japan. As a result, the United States took a leading role in creating the post–World War II international order, an order that was expected to maintain peace and economic prosperity in the world.

As the end of World War II was imminent, representatives of the United States and Great Britain met to discuss the post-war international order. One of these meetings took place in July 1944 in Bretton Woods, New Hampshire, and became known as the Bretton Woods Conference. Harry Dexter White, assistant secretary of the Treasury in the United States, led the US delegation, and John Maynard Keynes, adviser to the Treasury in the United Kingdom, led the delegation from Great Britain. The United States, Great Britain, and 42 Allied nations sent representatives to the conference. Yet, the participation of these 44 states was only relevant to the extent that they supported either the American or the British side.¹⁹

During the conference, the US and British delegations presented proposals for the establishment of the world economic system. The United States wanted to create an international order that was strong enough to promote international economic stability. Their main objective was to avoid another economic crisis like that of 1929. Great Britain’s proposal was more focused on reconstruction, but the British had difficulty garnering support. In the end, the US proposal prevailed, with compromises. As a result, the Bretton Woods System reflected US concerns in the post–World War II period. For instance, the United States accepted the British suggestion that governments should stimulate their economies and promote international trade without competitive currency devaluations. According to the British delegation, if state governments followed this prescription, the world economy would be in balance and a future crisis like the one of 1929 would be averted.

In the end, the Bretton Woods Conference created two international financial institutions, the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development, which became known as the World Bank. These two institutions were based on the belief that global collective action was necessary to guarantee international economic stability and rebuild Europe.

During the conference, there were also attempts to create a third institution to promote and regulate international trade. However, trade is a highly sensitive issue, especially to weaker states. Therefore, the third institution was not created in the conference, but discussions continued, and in 1947, the Havana Letter established the General Agreement on Tariffs and Trade (GATT). In 1995, the GATT gave way to the World Trade Organization (WTO).

The International Monetary Fund

At the time of the Bretton Woods conference, it was commonly believed that competitive devaluations among major international currencies had caused the 1929 financial crisis. Competitive devaluations happen when a country devalues its currency in relation to other countries to gain trade advantage, but other countries devalue their currencies in response. Though more recent evaluation has determined that other factors were responsible for the stock market crash,²⁰ the US delegation at Bretton Woods insisted on the creation of a strict international monetary system (as a way to prevent future economic crises) and a return to the gold standard, the monetary system in which the standard unit of account is a fixed quantity of gold.

The US economy had maintained a substantial surplus in the balance of trade during the war years and controlled a significant part of the world’s gold reserves. As a result, confidence in the value of the US dollar was widespread. Capitalizing on the situation, the US delegation proposed a system backed by the US dollar and assured that the US government would guarantee that every dollar was backed by gold—one ounce of gold per 35 US dollars (USD). Other currencies would have a fixed parity with gold and also with the US dollar. The IMF would be responsible for monitoring the value of other currencies against the dollar.

After much deliberation, it was agreed that international currencies could deviate 1 percent from their fixed rates without previous consultation with the Fund. Yet, the Fund should be notified of any deviations greater than 1 percent but smaller than 10 percent. Only in cases of fundamental imbalance could the IMF authorize devaluations greater than 10 percent.²¹

Though this arrangement seemed to solve the problem of competitive devaluations, there was still the problem of a lack of international liquidity, that is, a lack of money or gold in the international market. Much of the liquidity problem was solved through the Marshall Plan, a program through which the United States sent USD 26 billion in war recovery aid to Europe and Japan between 1946 and 1949.

Even with the disbursement of the grants and loans, the American balance of payment, or the difference in value between all payments made to a country and the payments the country has made to the rest of the world, maintained a surplus of USD 6 billion,²² which helped extend the high confidence in the US dollar.

Yet, in order to establish the international monetary system, governments had to hold reserves, or money, gold, and other highly liquid assets that a country’s central bank or other monetary authority could use to meet financial obligations. In the United States, the Federal Reserve System (commonly referred to as the Fed) is the central bank, and it works to promote the effective operation of the economy. Reserves help to keep currencies at a fixed, or pegged, exchange rate, in which a currency’s value is fixed against the value of another currency, basket of currencies, or gold. For example, when a country runs a deficit in the balance of payment—that is, when payments a country makes exceed payments it receives and there is a shortage of money—the supply of its currency in the foreign exchange market exceeds the demand. If the forces of supply and demand were free, the price of the currency would fall to adjust to the market. However, to maintain the proposed fixed (or pegged) exchange rate, a government could not allow its currency to devalue or appreciate more than 1 percent. Thus, in cases when the forces of supply and demand threaten the price beyond the 1 percent margin, the government should intervene in the international market to buy back its currency, using its reserves in dollars or gold, until the price of supply and demand restabilize. So, under the Bretton Woods guidelines, governments should keep reserves and act to correct the devaluation or appreciation of their currency.

In reality, those currencies that maintained surpluses and appreciated were not corrected while the fixed exchange rate regime was in place. As a result, devaluations are often seen as synonymous with economic problems rather than as a mechanism for regulating the system. Over time, even the IMF began to discourage the practice of valuation.

The IMF’s original role was to maintain the parity between the US dollar and other currencies while eliminating currency exchange restrictions and thus facilitating the expansion of international trade. This was called the Bretton Woods System.

Delegates to the Bretton Woods conference decided that when a country joins the IMF, an initial quota would be assigned. The IMF has used a quota formula to assess a country’s position in relation to members of comparable economic size and characteristics and thus establish the quota. The quota determines the member’s maximum financial commitment to the IMF and its voting power, and it has a bearing on the member’s access to IMF financing.

The IMF in Practice

During its first years of operation, from 1949–1958, the Bretton Woods system was favorable to the United States, as the United States was the only country in the Western world with surpluses. The United States, backed by its economic superiority and concerned with communism, rushed to guarantee conditions for restructuring and growth for the Western European and Japanese economies.

In 1949, the United States was categorical in its recommendation of a restructuring of the exchange rate against the US dollar. The restructuring was massive. The devaluation allowed gains in relation to exports since, by inducing a reduction in costs and prices against the dollar, the devaluation allowed for a trade surplus. The result was that the United States ran deficits throughout the 1950s. Initially, such deficits were not a cause of worry; the United States had understood that deficits were necessary for rebuilding the European economy and stopping communism.

Nevertheless, in 1958 the weakness of the dollar became evident. The first sign of concern came in the form of the establishment of conversion rates between European currencies. Until then, there was a conversion rate between each currency and gold as well as the dollar, but not between the currencies themselves. The adoption of conversion rates made it easier to transfer credit between European countries and thus increased the flow of investments and international trade in Europe.

Between 1958 and 1965, American corporations made huge investments in the European market, raising US concerns about the deficit and worries about foreign direct investment (FDI)—one company’s investment in a business based in another country. American deficits and investments in Europe resulted in an overabundance of US dollars in the international system, and with that abundance the dollar lost its credibility in the international market, and several countries that kept their reserves in dollars exchanged them for gold.

As countries exchanged their dollars for gold, the demand for gold increased, and when the supply did not meet the demand, the price of gold increased. As the gold standard was in place at that time, backing the US dollar by gold became more expensive. In an attempt to stop gold from appreciating on the international market, the United States briefly put its gold reserves on sale, stopping after the level of gold reserves decreased considerably. Likewise, as the demand for dollars decreased and the supply exceeded the demand, the price of the dollar decreased—that is, the excessive supply of the dollar in the international market led to a devaluation, and without the option to sell more gold on the international market, the United States was pressured to devalue its currency but met this pressure with considerable resistance.

In 1964, President Lyndon Johnson increased American participation in the Vietnam War. In the long run, this increased participation proved disastrous not only for the US economy, but also for the world economy. Although American economists urged the government to increase the tax burden to pay for war expenses, taxes were only readjusted in 1967, when the debt was already quite large.

All of these difficulties led the United States to pressure the IMF to create special drawing rights (SDR) in 1969. Member countries’ quotas have been translated to SDRs, the IMF’s unit of account. SDRs represent a claim to currency held by IMF member countries for which they may be exchanged. These units of account, issued by the IMF, were intended to increase the liquidity of the monetary system and reduce the world’s dependence on gold and the dollar, its main reserves. Initially, USD 3.5 billion in SDRs were issued. The SDRs emerged when the world was already drowning in excessive liquidity of dollars.²³

Faced with this situation, in August 1971, President Richard Nixon announced a reform package that unilaterally ended the conversion of the dollar into gold and devalued the American currency by 7 percent. With these measures, the Bretton Woods system came to an end. In 1972, the dollar suffered another devaluation, further reducing the US debt.

With the end of the Bretton Woods system, the functions of the IMF were revised. At that moment, the world was going through a new phase.

Conditionalities

Under pressure from the United States in the new economic order of the 1970s, the IMF began attaching conditionalities, policy actions a country agreed to take in exchange for the receipt of financial support, to IMF loans.²⁴ New York University professor Adam Przeworski and Princeton University professor James Raymond Vreeland suggest that conditionalities are a penalty.²⁵ This conception makes sense if you consider that the poorest countries seek the IMF’s assistance more often than the richest ones.²⁶ These countries’ pressing needs for credit put them in a vulnerable position, especially when conditionalities follow a “one size fits all” approach that forces strict monetary and fiscal policies on every borrower, irrespective of a particular borrower’s circumstances, as critics like Columbia University professor Joseph E. Stiglitz²⁷ contend. However, more recent literature has shown that the IMF does tailor conditionalities to each borrower.²⁸ According to University of Rochester professor Randall Warren Stone, there is evidence that the more problematic a country’s economic situation, the looser the conditionalities the IMF will impose. Regardless of how well the IMF tailors conditionalities, because borrower countries cannot opt out of them, they can be seen as a way IMF programs limit these countries’ sovereignty.

In the early 1990s, developing countries facing balance of payments problems, currency devaluation, and macroeconomic instability turned to the IMF seeking credit and advice.²⁹ IMF bureaucrats and representatives of member countries responded with a program designed to promote economic stability. The program, which became known as the Washington Consensus, was intended to promote fiscal balance, sound macroeconomic indicators, increased participation in the international flow of goods and services, and, ultimately, growth and development.

Conditionalities function as a guarantee that a loan will be repaid, but the IMF is not an ordinary creditor, and developing countries with economic imbalances seek more than the Fund’s credit. They seek credibility since the IMF’s decision to lend sends a message to the international community, including financial markets, about its trust in the borrower’s ability to overcome the crisis. For that reason, when the Fund disburses a loan, it has high expectations that borrowers’ economic performances will improve. Such expectations appease financial investors’ uncertainties about the market, and investments are more likely to return. Nevertheless, the Fund puts its reputation at risk. Although the Fund’s image and reputation suffer from eventual disastrous outcomes of the implementation of market and financial reforms in certain countries, it is not always clear whether the IMF’s policy recommendations or domestic governments’ ability to implement economic policies are to blame. In any case, such disastrous outcomes represent obstacles in the pathway to a prosperous global economy.

The World Bank

The IMF was the apple of the United States’ eye, and its creation consumed a majority of the time at the Bretton Woods conference. The creation of the World Bank was only discussed in the last few days. Under John Maynard Keynes’s guidance, it was established that the Bank’s original role would be to help rebuild the economies of countries devastated by war and to promote the economic development of developing countries. The Bank’s first loan was to France, and loans to other European countries ensued.³⁰ However, in 1947, as the Marshall Plan ended up taking the lead in the reconstruction effort in Europe, the World Bank had to adapt, and it swiftly shifted to funding development projects around the world in sectors such as power, irrigation, and transportation. In 1948, Chile was the recipient of the Bank’s first loan to a non-European country in the amount of USD 13.5 million for hydroelectric power generation.³¹

In the 1970s, about 780 million people in developing countries (excluding China and other centrally planned economies) were living in extreme poverty, without basic human necessities like food, clean drinking water, sanitation, and shelter. In a speech in 1973, World Bank President Robert McNamara first described this condition as absolute poverty.³² In response to the situation, the World Bank turned its focus to directly helping the poor. In the same speech, McNamara communicated the World Bank’s twin goals of accelerating economic growth while reducing poverty. The incorporation of these concepts in the Bank’s mission transformed it into the institution focused on poverty alleviation and development promotion that it is today.³³

The 1980s and 1990s presented the world with new challenges related to oil shocks, shortages of oil and oil derivatives in the Western world that resulted from oil exporting countries’ decision to reduce oil production; debt crises, as countries were unable to pay their debts; and environmentalism. The Bank responded by incorporating new skills and safeguards into its work. As a result, the Bank began to provide loans for structural adjustments, with the approval of the IMF. In other words, the Bank’s loans were linked to the Fund’s conditionalities, such as fiscal discipline, tax reform, and liberalization of foreign direct investment. The overall effectiveness of these loans was the target of criticism from the international community.³⁴

In the 1990s, with the end of the Cold War and the collapse of the Soviet Union, the Bank started to assist former Soviet nations in transitioning their economies, and many of these recently recognized nation-states became World Bank members. During this time, the Bank also started to focus more closely on safeguarding the environment through sustainable development and poverty reduction.

Figure 4.3 The number of people living in extreme poverty has been declining since the 1990s. (credit: “World population living in extreme poverty, World, 1820 to 2015” by Our World in Data, CC BY 4.0)

In the late 1990s, the World Bank refocused its efforts on conflict prevention, post-conflict reconstruction, and development promotion. The period brought concern about the impact of corruption on the success of lending operations, which led the Bank to sponsor an anti-corruption strategy.

The mid-2000s brought the idea of the World Bank as a knowledge institution, an institution that collects and publishes data and reports, and by 2010, the Bank initiated a more transparent approach to development by providing policy makers in borrowing countries with reliable debt information to help them make informed borrowing decisions. For instance, following the Millennium Development Goals in 2000 and the Sustainable Development Goals in 2015, the World Bank stressed community-driven development, the safeguard of vulnerable groups, and the impact of, mitigation of, and adaptation to climate change.³⁵

From the GATT to the WTO

The Bretton Woods conference was expected to establish a third institution, the International Trade Organization (ITO), to promote international trade and economic cooperation. Even though the institution was not created during the conference, negotiations aimed at its creation continued.

In December 1945, following the end of World War II, 15 countries engaged in talks to move away from protectionist policies, which had been the norm since the early 1930s, and to promote trade liberalization. The talks produced an agreement with about 45,000 tariff concessions, preferential rates on taxes or duties to be paid on imports, which marked the beginning of the General Agreement on Tariffs and Trade (GATT).³⁶ At the time the deal was signed in October 1947, the team had expanded to include 23 members. The deal came into effect in June 1948.

Negotiations to establish the ITO continued at the UN Conference on Trade and Employment in Havana, Cuba, in late 1947, less than a month after the GATT was signed. Curiously, the GATT included provisions for the relationship between the GATT and the ITO, but also for the GATT’s role in the case that the ITO ended up not being established.

All 23 GATT signatories participated in the Havana Conference. Their initial goal was to create the ITO as a specialized agency of the United Nations. The plan envisioned a powerful ITO that would regulate trade and labor and engage in commodity and international investment negotiations, among other responsibilities.

The ITO Charter was agreed to in Havana in March 1948, but it was never ratified in some relevant countries, including the United States. Though the US government had been a driving force during negotiations, the ITO faced serious opposition in the US Congress.³⁷ In 1950, when the US government announced that it would no longer pursue congressional ratification of the ITO Charter, the ITO was dead. As a result, the GATT became the multilateral instrument regulating international trade from 1948 until the WTO was established, almost 50 years later, in 1995.³⁸ During this period, the GATT’s principles remained faithful to its origins, and the efforts to reduce international tariffs were unabated. GATT signatories met in a series of multilateral negotiations, commonly known as trade rounds (Table 4.1). Some of the most relevant advances in international trade liberalization were agreed to in these rounds.

Sections on anti-dumping, or tariffs imposed on imports to increase their prices to market value, and development promotion were included in the 1960s and in plurilateral agreements, agreements between a small number of signatories,³⁹ in the 1970s. In fact, the Tokyo Round (1973–1979) was the first major attempt to confront non-tariff trade barriers—trade restrictions such as quotas, embargos, or sanctions. The last round, the Uruguay Round (1986–1994), resulted in a new set of agreements, including the creation of the World Trade Organization.⁴⁰

The GATT was a relevant instrument to international trade liberalization from the late 1940s to 1995. While the GATT was in place, there was a continuous reduction of tariff and non-tariff barriers across the globe. The increase in the volume of international trade surpassed production growth; that is, more unfinished products were traded among countries. The participation of developing countries in the Uruguay Round indicated that the GATT was recognized as relevant to multilateral trade.

Table 4.1 GATT Trade Rounds (source: https://www.researchgate.net/figure/The-GATT-Trade-Rounds_tbl3_5056860)

Nevertheless, there were problems. Economic recessions throughout the Western world in the 1970s and 1980s led to increases in protectionist measures, especially for sectors facing increased international competition. Resulting high unemployment and constant factory closures led governments in developed countries to seek bilateral agreements with competitors, discarding multilateralism. Agricultural trade has never been discussed during the GATT rounds. Governments adopted subsidies—grants to individuals or firms, usually in the form of a cash payment from the government or a tax cut. Trade in services, which was not covered by GATT rules, had increased throughout the 1980s and 1990s. Moreover, GATT’s institutional structure and its dispute settlement system were the cause of concern.

These and other factors convinced GATT members to renew attempts to establish an institution to promote trade liberalization. Their efforts resulted in the World Trade Organization (WTO).

The Uruguay Round and earlier GATT negotiations form the basis of the WTO’s current work. WTO agreements cover goods, services, and intellectual property. The institution establishes governing principles of liberalization and permitted exceptions for member countries. It sets procedures for settling disputes, prescribing special treatment for developing countries.

Figure 4.4 In 2015, Kenyan president Uhuru Kenyatta spoke during the opening of the 10th World Trade Organization (WTO) ministerial conference in the Kenyan capital, Nairobi, the first to be held on African soil. (credit: “10th WTO Ministerial Meeting Opening_0016” by Make It Kenya/Stuart Price/Flickr, Public Domain)

Where countries have sought to lower trade barriers, negotiations have helped to liberalize trade. The system’s overriding purpose is to help trade flow as freely as possible so long as there are no undesirable side effects.

An important task of the WTO is managing the dispute settlement process. Trade relations often involve conflicts, and having an international institution to manage these conflicts in accordance with an agreed-upon legal foundation has proven beneficial. The WTO’s procedure underscores the rule of law, and it makes the trading system more secure and predictable. Dispute settlement is the central pillar of the multilateral trading system and one of WTO’s main contributions to the stability of the global economy. Without a means of settling disputes, the rules-based system would be less effective because there would be no way to enforce those rules.

Meet a Professional

Laíssa Vasconcelos, International Trade Coordinator

International grain commerce feeds the world. During the COVID-19 pandemic, the Latin American grain industry worked hard to adapt in order to ensure the maintenance of the supply of grains to the world population.

Ensuring international grain supply is part of Laíssa Vasconcelos’s day-to-day work. Laíssa is an international trade coordinator at a subsidiary of a multinational corporation in Brazil that exports grains produced in Latin America all over the world.

Please explain what you do for your organization.
I’m an international trade coordinator. I coordinate grain purchase contracts and export operations at a subsidiary of a large corporation in Brazil. In addition to managing internal purchases and exports, I support offshore operations and international arbitration panels, and I have an advisory role on the company’s Environmental, Social, and Governance (ESG) committee. ESG analyses look at how companies affect the environment and society and also how governance within the company occurs—for example, if the company is promoting equity and diversity. Investors are increasingly relying on ESG indicators to make investment decisions.

How did you get involved in your position?
I have a degree in International Relations from PUC Goiás, Brazil and an MBA from FGV, also in Brazil. I entered the company to perform technical tasks, but I was interested in learning more, so in parallel I tried to understand the connections between the activities of my department and those of other departments. Eventually, I become a reference in problem solving and got promoted.

What advice would you give students who are interested in your line of work?
Try to get a job where you want to work, even if you have to start at the bottom. Do your job well and pay attention to what’s going on around you. Learn how what you’re doing fits into the bigger picture. When you work hard and learn, people will see the value you bring to the company, and you’ll be able to advance to the point where you can do work that you really enjoy. Be proactive and develop skills that put you in a position to be considered for roles in different areas.

4.4 The Post–Cold War Period and Modernization Theory

Learning Outcomes

By the end of this section, you will be able to:

• Describe changes inaugurated with the end of the Cold War.
• Explain key tenets of modernization theory.
• Cite a counterargument to modernization theory.

From its beginning in the late 19th century until the end of the Cold War in 1989, international political economy was almost exclusively focused on the world’s international financial powers—liberal democracies in Western European countries and the United States. The majority of the research and discussions in the field did not include countries in regions that had different political and economic systems. Even when these other countries participated in international relations, as was the case in the Bretton Woods conference, they were considered mere spectators. The preferences of Western financial powers dominated the agenda.⁴¹

During the Cold War, economic transactions between the East and the West were very rare. Western liberal democracies interacted among themselves, and Eastern socialist republics did the same. The majority of international trade took place between the United States and European countries. However, the end of the Cold War highlighted the economic and political issues countries in other regions of the world, such as formerly communist and Latin American countries, were facing. With the end of the Cold War, the focus of IPE shifted from an exclusive interest in developed Western nations to promoting development across developing countries in different regions. Since the late 1940s, modernization theorists had been searching for ways to bring economic growth and democracy to developing societies.

Figure 4.5 Oneida Gómez holds a coffee plant in the nursery she has planted with the help of Blue Harvest, a Catholic Relief Services partnership with Keurig Dr Pepper and the Inter-American Development Bank’s SAFE Platform that aims to improve the water supply to help the agricultural economy in El Salvador. This is just one example of a huge number of development projects in the post–Cold War era. (credit: “Blue Harvest El Salvador” by Maren Barbee/Flickr, Public Domain)

Modernization theorist Seymour Martin Lipset was one of the first to propose a link between economic development and democracy. He argued that improved wealth and education levels would create the right conditions for the establishment of democratic institutions.⁴² Once people with low socioeconomic status are given access to education, Lipset contended, they become less committed to their existing ideologies and less isolated from people of other socioeconomic statuses. As these groups become more educated and politically active, they become part of the middle class, and as the middle class increases, it pushes for democratic institutions.

In general, the key argument of modernization theory is that economic growth promotes structural changes in society that lead to increased political representation and, eventually, to the establishment of democratic institutions. Nevertheless, even though most developed countries are democracies, it is difficult to establish a causal mechanism, or a link, between economic growth and democratic institutions.

UCLA emeritus professor Barbara Geddes, a political scientist who has examined developing societies for over 20 years, contends that modernization is the most empirically supported hypothesis about the suitable conditions for democratization.⁴³ Similarly, University of Chicago professor James A. Robinson has found statistical evidence indicating that economic development is highly correlated with democratization, even though the exact mechanism by which economic growth spurs democracy has not yet been uncovered.⁴⁴

New York University professor Adam Przeworski and Fundação Getúlio Vargas professor Fernando Limongi, two other prominent modernization scholars, argue that the impact of economic development in a society is so strong that once a country reaches a certain threshold of growth, a democratic regime will always survive. These scholars offer a metaphor to explain this relationship, suggesting that if modernization is a long walk, democracy is only the final step. In their empirical analyses, they find that transitions to democracy occur independently of the level of economic development (or high per capita income levels); however, once a transition happens, countries with higher levels of economic development tend to remain democratic.⁴⁵

Considering the difficulty of finding the causal mechanism between economic development and democracy, MIT professor Daron Acemoglu and colleagues have reevaluated the modernization hypothesis. They find that most studies that claim to have found a connection between economic development and democracy fail to account for relevant variables. They argue that events during critical historical moments lead to divergent economic and political outcomes—either promoting economic development and democracy or leading to poverty and authoritarianism. Thus, these scholars believe that these critical historical moments are an underlying cause of economic development and democracy.⁴⁶

The core debate in modernization theory has not been solved. While developing countries, with the support of international institutions such as the IMF, World Bank, and WTO, continue to pursue economic development, given the unwanted consequences of the market economy, the focus has shifted from development to sustainable development.

4.5 From the 1990s to the 2020s: Current Issues in IPE

Learning Outcomes

By the end of this section, you will be able to:

• Describe how IPE has changed in the decades following the end of the Cold War.
• Explain how governments react to international trade.
• Describe government responses to international finance and crises.
• Label the pros and cons of different exchange rate regimes.

The end of the Cold War opened new doors for IPE. Over the last four decades, numerous developments, such as intensifying globalization, trade liberalization, international migration, poverty reduction, growing inequality, and climate change, embedded in an unprecedented wave of technology development, have profoundly altered not only what IPE examines, but how.

Since the late 1980s, as the focus of IPE shifted from a handful of developed countries to incorporate many others in several different regions, its “international” aspect has become more pronounced, as have the accompanying complexities.

IPE has become more focused on empirical analyses. Sophisticated software and advanced statistical techniques now allow researchers to measure variables once considered to be unquantifiable. Today, IPE researchers start conversations based on the validity of their empirical findings.

Three key issue areas have risen to prominence in contemporary IPE: globalization and international trade, international finance and crises, and exchange rate regimes. In keeping with trends in IPE, this chapter examines these issues through an empirical rather than a historical lens.

Globalization and International Trade

The international system pressures states to act in ways that promote the dissemination of international norms. For instance, ideas encouraging globalization have motivated trade liberalization since the 1990s.⁴⁷ Spanish sociologist Manuel Castells defines globalization in economic terms as:

“An economy whose core activities work as a unit in real time on a planetary scale. Thus capital markets are interconnected worldwide, so that savings and investment in all countries . . . depend for their performance on the evolution and behavior of global financial markets.”⁴⁸

The interconnectedness of markets poses an opportunity or a threat to a country, depending on the country’s ability to compete in the international market.

A large body of IPE literature examines government responses to globalization. Political scientists like Yale University professor David R. Cameron, Cornell University professor Peter J. Katzenstein, and University of Southern California professor Geoffrey Garret have demonstrated that under the pressure of leftist parties, domestic governments tend to expand in order to counterbalance the volatility of an open economy and to protect impacted workers.⁴⁹ An extensive body of political economy literature discusses the impact of globalization on domestic governments, asking whether globalization causes the government to contract or to expand.

Trade policies distribute the benefits and costs of trade among groups in society,⁵⁰ favoring either market liberalization or protectionism. Liberal trade policies promote lower prices across the board, and with this, domestic industries face international competition. Consumers win, but workers in import-competing industries that cannot keep up with international competition lose. On the other hand, protectionist trade policies safeguard import-competing industries that are unable to compete internationally but increase prices to consumers. That is, while trade liberalization promotes widespread benefits with localized costs, protectionism does the opposite; it promotes limited benefits with generalized costs.

Show Me the Data

Figure 4.6 In recent years, globalization has retreated for the first time since World War I. (sources: Our World in Data; Pearson Institute for International Economics; attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license)

Globalization calls for market liberalization. It decreases government participation in the economy by allowing the market to regulate the movement of capital, labor, goods, and services across borders. As a result, businesses move production plants from one location to another in search of competitive advantages; production costs decrease, and trade volumes increase.

The economic gains from trade liberalization are widely documented,⁵¹ but the dislocation of production plants to areas where cheaper labor is available has left behind unemployed factory workers. While trade liberalization leads to lower prices and brings new consumers to the economy, increasing the quality of life of millions of people, it also generates unemployment when factories that, in the face of international competition, cannot keep their doors open end up exiting the market. New York University political scientist Fiona McGillivray demonstrated that, when faced with fierce international competition, entire industry sectors struggle, and as more factories close, more workers become unemployed.⁵²

Factory workers’ skills tend to be industry specific. Thus, if unemployment is an industry problem, unemployed workers have difficulty finding similar jobs with comparable wages and benefits. For example, a welder in a steel factory has abilities that cannot be easily translated to other industries. Consequently, unemployed workers—in this example, steel workers—are left with few options. They may accept a low-skilled, low-paying, limited benefits job; enroll for professional (re)training; and/or remain unemployed. Considering the difficulties of professional (re)training, Harvard University professor Torben Iversen and former Berlin Social Science Center researcher Thomas R. Cusak have shown that workers who lose their jobs due to international competition tend to remain unemployed for long periods of time.⁵³

Studies about the impacts of globalization on government spending tend to focus on workers. Globalization affects factory owners and investors differently than it impacts workers, and thus factory owners and investors tend to deal with market volatility differently. Investors usually save money for rough periods, buy insurance to protect themselves from market volatility, and pressure the government for assistance. Workers do not usually have extra money to save or with which to buy insurance and thus are left only with the option of resorting to the government for assistance. Whether the government is composed of left/labor or right/liberal parties that espouse liberal economic ideologies, following the ideas initially proposed by Adam Smith impacts the size of the government. Majority left/labor governments tend to spend significantly more on welfare policies, such as unemployment benefits and food stamps. These policies generate spending and increase the size of the government. Right/liberal majority governments tend to cut welfare expenses, spend less, and thus decrease the size of the government.

Winners and Losers in International Trade

Several researchers have studied people’s preferences about international trade and have found that the key variables influencing preferences toward globalization and market liberalization are 1) material gains and 2) education levels.

One can argue that an individual who works in an import-competing industry would be a loser in an environment of trade liberalization and thus would tend to oppose it. Suppose that an industry in Country A does not have comparative advantage in sugar production. Countries B, C, and D have more favorable conditions to produce it and therefore can produce better quality sugar at a lower cost. What would happen if Country A’s government did away with trade barriers, including tariff and non-tariff barriers, on sugar imports? Country A would receive more of the higher quality, cheaper sugar from Countries B, C, and D. The sugar industry in Country A, which had adopted liberal trade policies, would face pressure from the international market to become more efficient and to produce cheaper sugar. If the sugar industry in Country A were not able to keep up with international quality and prices, it would, with time, get out of the market. Consumers in Country A would not buy sugar from Country A producers; they would prefer the better quality and cheaper sugar from Countries B, C, and D. Sugar producers and workers in Country A would be worse off in the short term and would close their doors, and workers would lose their jobs.

Though workers would suffer, the country as a whole would get better sugar at a lower price, and this is why, economically speaking, trade liberalization tends to favor markets in general as they promote better quality and/or lower prices.

Suppose a person works in the sugar industry in Country C. If world governments do away with agricultural trade barriers, sugar producers in Country C would sell their product on the international market. Both landowners and agriculture workers in Country C would be better off. As a result, people who work in export industries tend to favor free trade policies.

Some scholars argue that people’s opinions on trade policy also depend on education levels. Educated (or highly skilled) individuals tend to be more likely to favor trade liberalization. Although trade liberalization generates winners and losers in particular industry sectors in the short term, such as export or import industries, the preferences of high-skilled individuals toward trade do not go hand in hand with their personal material gains or losses. Some possible explanations for this seemingly irrational behavior include the fact that these high-skilled individuals may find other jobs with relative ease in different industries and the fact that they also tend to reap the benefits of better quality and cheaper exports in the domestic market.

Yale University professor Kenneth F. Scheve and Dartmouth professor Matthew J. Slaughter illustrate the argument that a person’s level of education heavily influences their perceptions of trade liberalization.⁵⁴ They surveyed individuals in the United States and found that individual preferences toward trade policies are a function of both material effects and skill levels (measured as educational attainment or occupation). Fiscal and municipal management specialist at the Inter-American Development Bank Martin Ardanaz, Columbia University professor M. Victoria Murillo, and University of Houston professor Pablo M. Pinto replicated Scheve and Slaughter’s survey in Argentina and also found that support for economic integration depends on both material effects and education levels.⁵⁵

Suppose that the United States is Country A in the example above. That is, although the United States does not have a competitive advantage in sugar production, it produces it anyway. The sugar industry creates several jobs and supplies a considerable portion of the sugar consumed in the country. However, given that the United States does not have a comparative advantage when it comes to sugar production, the sugar produced in the United States is more expensive than the sugar produced in a country with a comparative advantage in sugar production, like Brazil, for example. Therefore, to make sure that sugar made in America can compete in the market, the US government subsidizes its production. These types of subsidies are payments or incentives the government grants to firms in the form of cash payments or tax cuts. Subsidies can be used to promote industry sectors considered relevant to a country, such as the sugar industry in the United States. In the end, although Americans pay higher prices for sugar, some American jobs are kept. If the government eliminated sugar subsidies, consumers would pay lower prices, but sugar producers and workers would be forced out of the market.

International Finance and Crises

Financial crises are a regular feature of the international economy. Retraction, and sometimes recession, follow cycles of economic expansion and growth. When a crisis hits, it can have dire consequences including effects like capital flight, the large-scale exit of money from a country as a result of market uncertainty; decreased investments; unemployment; and economic contraction. In such situations, governments take actions to lessen the negative effects of the crisis and to reverse the downward trajectory of the economy.

IPE examines the economic consequences of government actions. When financial crises like the American financial crisis of 2008, which is considered the worst since the Great Depression, do occur, governments are limited in the ways they can respond to them.⁵⁶

The politics that led to the 2008 financial crisis had their roots in George W. Bush–era tax cuts and the increased international borrowing of the early 2000s. The international inflow of money to the United States made it easy for the government and individuals to borrow at low interest rates. Intense borrowing created huge deficits in the balance of payments. At one point, the United States had debts equivalent to 5 percent of its gross domestic product (GDP), the sum of everything produced in a country in a given period. A similar level of debt would certainly affect the reputation of other countries, especially developing ones, making it more difficult for them to get loans,⁵⁷ but creditors decided to overlook the situation when it happened in the United States. The extensive amount of money that poured into the market stimulated the American economy. People were consuming a lot; the demand for imported goods and services rose, and housing prices skyrocketed.⁵⁸

Politicians like former United States Federal Reserve Chairs Alan Greenspan and Ben Bernanke refused to acknowledge these warning signs. They suggested that high debt and an overstimulated economy could indicate bumps ahead in other economies, but not in the United States. Greenspan, Bernanke, and their followers made the case for “an economic American exceptionalism,” but in the end, the United States was not entirely different from other countries in the world.

Figure 4.7 Protesters rally in Minneapolis calling for accountability in the banking industry, the prosecution of bankers for the 2008 financial crisis, and relief for families and communities devastated by foreclosures. (credit: “Rally to demand accountability from the financial institutions and legal action against bankers” by Fibonacci Blue/Flickr, CC BY 2.0)

A slowdown in economic activity opened up the doors for a financial crisis that deepened with massive capital flight. In the end, fiscal and current account deficits were indeed indications of a serious financial crisis ahead. When the Obama administration took office in January 2009, it followed Keynesian guidelines, taking significant steps to intervene in the economy, including bailing out major corporations, to lessen the impacts of the crisis.

The American government did not have to act to secure an exchange rate, as most countries who go through such a crisis do, but it did act to reduce capital flight and stimulate investments. Domestic actors called for unemployment stabilization and eventual deficit reduction. The government’s ability to bail out big corporations through the disbursement of loans during the crisis indicates that there might indeed be some form of “American economic exceptionalism.” Perhaps no country other than the United States could have contradicted IMF prescriptions.

The actions of the American government in response to the 2008 financial crisis were markedly different from the actions of other states. Greece provides a telling example. Greece has had to conform to fiscal policy austerity as prescribed by international institutions, while the US government has been able to take whatever course of action it chooses.

Different governments have access to different actions during a financial crisis. The United States’ seemingly successful recovery implies that a government’s ability to respond to a financial crisis depends not only on domestic incentives but also on its power to pursue an expansionary economic policy in times when this action would not at all be recommended. Though more powerful countries can stand to take more risks than less powerful ones, only the United States, which is the world’s financial hegemon,⁵⁹ has the leeway to take this course of action. This exception takes one back to the establishment of the post–World War II international financial system where the United States had the most prominent role.

Exchange Rate Regimes in a Globalized Economy

As discussed above, the Bretton Woods monetary system established a gold standard under which governments kept gold in their treasuries to back the value of their currencies. In 1971, the gold standard was extinguished, and since then the value of national currencies has been based on trust, or their perceived value. Whenever an individual buys something, they believe that good or service is worth a portion of their money.

The demand for goods produced in one country creates the demand for that country’s currency. As a result, exchange rates are established. An exchange rate is the price of a currency relative to another currency. A government can use several mechanisms to manipulate the value of its currency. By creating incentives to sell abroad and buy domestically, governments change the relative prices of their currencies. Such incentives can occur through trade (increased output, but especially innovation and productivity). In terms of monetary policy, the government can print money, or it can increase interest rates to curb consumption. A government can also manipulate the value of the currency by establishing changes in the exchange rate regime.

While almost every economist would agree that a free trade policy is superior to imposing trade barriers, when it comes to exchange rates, there is no agreement on which policy is best. Governments can choose from among three main exchange rate regimes: a floating (flexible) exchange rate, a fixed (pegged) exchange rate, and a multilateral exchange rate.

In a floating exchange rate regime, the supply and demand of a currency in the market determine its value. For example, when American consumers want to buy more Mexican products, the demand for Mexican pesos rises and, consequently, the price for pesos increases. Americans will spend more dollars to buy pesos. When Mexican consumers want to buy more American products, the demand for dollars increases, and the price of dollars also increases. Pesos become devaluated in relation to the dollar. In a floating exchange rate regime, the prices of currencies float naturally according to the pressures of supply and demand. Theoretically, in the long run there is an equilibrium among all the currencies in the market, and the balance of payments of every participating country is zero.

A government may decide to fix the exchange rate regime. In such cases, no matter how supply and demand forces interact, exchange rates remain constant. No matter how much Americans demand Mexican agricultural products or vehicles, if the Mexican government maintains a fixed exchange rate, 1 peso will be equivalent to 2 dollars, for example. The mechanisms through which a government maintains a fixed exchange rate regime are market interventions, such as using reserves to correct the devaluation or appreciation of their currency, and fiscal and monetary policies, which refer to governments’ decisions about taxation and available credit in the economy. A government usually fixes an exchange rate to stimulate exports/reduce imports and avoid large deficits on the balance of payments.

In a multilateral exchange rate regime, governments allow their currencies to fluctuate within margins. There is a floor (the lowest allowed value) and a ceiling (the highest allowed value), and whenever the currency reaches either the floor or the ceiling, the government intervenes using marketing interventions and fiscal and monetary policies to change the relative price of a currency.

Each exchange rate regime has pros and cons. On the positive side, a fixed exchange rate regime stabilizes the flow of international trade since it promotes predictability and offers an anchor for macroeconomic policies. However, a fixed exchange rate regime may result in losses in either output or employment, depending on the country’s position as an importer or exporter. Under a fixed exchange rate regime, politicians lack the ability to manipulate monetary policy for electoral or partisan reasons.⁶⁰ Meanwhile, a floating exchange rate regime can be unpredictable and may not help to stabilize the flow of trade, but it allows for the political manipulation of the currency.

A politicians’ incentives to manipulate a currency may conflict with what is best for the economy or with societal preferences. For example, prior to an election a politician may promise not to fix the exchange rate regime. Although fixed exchange rates bring stabilization, they tie the government’s hands when it comes to the manipulation of the currency. Exchange rates are more likely to be fixed in the aftermath of elections.

When politics and the economy interact, how interest rates should be balanced is unclear. Therefore, an independent central bank, or a central bank with the power to define monetary policies without government influence, may be a good option to promote an exchange rate regime and monetary policies more connected to an economic agenda and less responsive to electoral politics.

The movement toward globalization and trade liberalization since the 1990s has resulted in a tremendous increase in capital mobility, the ability to move capital from one country to another, and shifted much of domestic politics toward floating exchange rate regimes. Movements in exchange rate regimes affect the return on investments, and investors exert pressure on governments to adjust rates in ways that benefit them. In the short term, the shift to capital mobility and financial integration (the process that connects financial markets all over the world) favors capitalists with mobile assets, such as investors, and disfavors those not so mobile, such as manufacturing or farming. In the long run, this trend tends to favor the mobile capital owners over workers.

It is hard for economists to agree on an optimal exchange rate regime because socioeconomic issues and electoral politics influence which regime is best for a given country. In order to avoid some of these questions, many countries have independent central banks that are more tuned to socioeconomic aspects and less immersed in party politics.

4.6 Considering Poverty, Inequality, and the Environmental Crisis

Learning Outcomes

By the end of this section, you will be able to:

• Explain the origins of poverty, inequality, and the environmental crisis.
• Discuss prominent criticisms of liberal economic theories and the market economy.

As the David P. Levine quotes included in the above discussion of the advent of the liberal economy suggest, the market economy has provided its members with great opportunities but has also confronted them with great dangers. The advent of liberalism brought the possibility of creating wealth and the continuous development of market economies, which culminated in unprecedented levels of globalization and trade liberalization since the 1990s. Innovation and scientific and technological developments are intrinsically associated with the incentives the liberal market provides. In other words, as people like Microsoft cofounder Bill Gates and cofounder of Apple Steve Jobs put their minds to work, they create amazing things that can be produced on a large scale for the consumption of billions of people around the world. People like Gates and Jobs are rewarded with wealth, and this possibility fuels entrepreneurs across the globe and propels them to create, find solutions to difficult problems, and transform how people live their lives.

However, dangers associated with capitalism, like poverty, inequality, and environmental crises, are the other side of the coin. Many authors argue that these dangers are inescapable consequences of capitalism.

Poverty and Inequality

Like Levine, several scholars have suggested that poverty is an inescapable feature of capitalism, or the market economy. Recall that, with the advent of the market economy, it became possible to create wealth. Ideas that circulated during the Enlightenment, such as laissez-faire economics, an emphasis on individual freedom, and the protection of property rights by a limited government, promoted wealth creation and capital accumulation. At the same time, these ideas have exacerbated poverty and inequality.

Under other economic systems, such as mercantilism, wealth was fixed, and monarchs and the aristocracy lived lavish lives, while the rest of the population lived frugal lives. As there was no trade among countries, there was not much to consume. People ate what they planted or raised, wore what they sewed, and when things went well, they could barter some excess with their neighbors. As they were all in the same boat, everyone had similar living conditions, and there was no striking inequality. Only a tiny portion of the population, the royals, lived differently.

The Enlightenment brought profound changes, from the advent of markets to urbanization and a new relationship with private property, including land. At the same time that the market economy was being developed during the Enlightenment period, the Industrial Revolution made it possible to produce goods for mass consumption.

A new social class emerged: the middle class. While those people in the middle class were able to consume much more than before, many people were relegated to a condition of poverty, where they did not participate in the markets or had no plot of land to subsist on. Those who were poor had no means by which to fulfill their basic needs for water, food, and shelter. This condition was different from the destitute condition of the mercantilist period, when people had at least their basic needs met.

Several authors argue that the same mechanism that produces wealth and innovation also creates poverty, inequality, and environmental crises. In other words, poverty, inequality, and environmental crises are understood as unwanted consequences of the market economy.

While the industrial process creates affordable goods for mass consumption, it has had unwanted consequences. For example, those who had been displaced from the land where they used to live started to sell their labor in exchange for a wage. Note that there were no wages during mercantilism; the relationship with work was completely different, and the landlord took care of the families that lived on his land. The British television series Downton Abbey, set in the early 20th century, illustrates the change from a world where the landlord was responsible for caring for the families that lived on their land to a world where individuals were free and thus responsible for the care of themselves and their families. Note, however, that the changes illustrated in the show had been going on for almost a century.

The concept of wages creates a serious tension within the market economy: in order for workers to be able to satisfy the basic needs of their families, wages should be as high as possible. On the other hand, in order to keep production costs down and guarantee the profit of the capital owner, wages should be as low as possible.

This relationship between labor, wages, basic needs, and unemployment creates poverty. Most sell their labor in exchange for a wage that should allow the worker to provide for themselves and their family. If the labor is not specialized, the pool of people capable of working the job is large. If there are more individuals willing to sell their labor than actual demand for that type of labor, wages are lower and there is unemployment. The supply of capable workers exceeds the demand for workers with those skills. If, as a consequence of low wages or unemployment, a worker is unable to provide themselves and their families with basic goods, they are considered poor.

Figure 4.8 In the United States, individuals who are unemployed may submit claims for unemployment benefits; however, these benefits are often not enough on their own to support a family.⁶¹ (credit: “Unemployment Office” by Burt Lum/Flickr, CC BY 2.0)

The generalized suffering among the poor during the Industrial Revolution prompted several political philosophers to search for answers to solve the problems of growing poverty and inequality. At the beginning of the 19th century, these political philosophers proposed a variety of responses to the challenge. Although each of their proposals had singular characteristics, each involved the social ownership of the means of production, or the control of farms, factories, and business offices by the people. Thus, these political philosophers became known as socialists.

Socialist thinkers proposed forms of societal organization that upset the foundations of the market economy. There was a general belief among socialists that this economic system could not satisfactorily address the problem of inequality of property or wealth, and thus they proposed not only the social ownership of the means of production but also a stronger government to coordinate and redistribute wealth in society. These ideas are in striking opposition with the classical liberalism advanced by Adam Smith, which promoted a laissez-faire economy, a free market with minimal government intervention.

Though many people associate socialist thinker Karl Marx with socialism or communism, the majority of his work concerns the market economy. Marx contended that, in order to end the exploitation of the proletariat⁶² by the owners of the means of production, workers should unite and rebel against the capitalists. While society prepared for the advent of communism,⁶³ a dictatorship of the proletariat—a socialist state—should govern.

Several countries underwent socialist revolutions in an attempt to implement socialist ideals at the expense of the market economy, individual freedoms, and property rights protected by a limited government.

Unlike socialist thinkers, some contend that poverty and inequality can be overcome from within the capitalist system. One of the most renowned proponents of overcoming poverty through technology development and investments, Jeffrey Sachs, authored The End of Poverty, published in 2005, which heavily influenced the global fight to overcome poverty.

In the book’s foreword, music celebrity and philanthropist Paul David Hewsen, better known as Bono, writes: “We are the first generation who can . . . unknot the whole tangle of bad trade, bad debt, and bad luck. The first generation that can end a corrupt relationship between the powerful and the weaker parts of the world which has been so wrong for so long.”⁶⁴ In the book, Sachs contends that “our generation is heir to two and a half centuries of economic progress.”⁶⁵ That is, since the Industrial Revolution and the Enlightenment in Europe, economic and technological developments have made it possible to meet basic human needs globally.

Given this opportunity, in order to end extreme poverty, Sachs calls for a commitment to embrace the Millennium Development Goals: raising the voices of the impoverished, redeeming the role of the United States in the world, adapting the roles of the IMF and the World Bank, strengthening the United Nations, and promoting science and sustainable development.⁶⁶ Sachs hoped that, by committing to these goals, the world could eliminate poverty by 2015.

Sachs’s standpoint represents a moral commitment to end poverty within the capitalist system. Poverty did not end by 2015, but the world has made progress toward the goal. Globalization and trade liberalization have increased since the 1990s, and both developed and developing countries have taken part in the process. Developing countries’ gains as a result of trade liberalization since the 1990s are in the billions of dollars added to GDP growth.⁶⁷

Economic integration has pulled billions of people out of poverty and increased their quality of life. The global poverty rate, defined as the percentage of people living at USD 1.90 a day or below, decreased from about 35 percent in 1990 to about 10 percent in 2017. Over the same time period, the number of people living at the global poverty rate has also consistently decreased, from nearly 2 billion to close to 689 million.⁶⁸

However, climate change, the COVID-19 pandemic, and other challenges threaten efforts to eradicate poverty. These threats jeopardize the attainment of the World Bank’s goal of bringing global extreme poverty to less than 3 percent by 2030. Global economic growth was predicted to decrease by 5.2 percent in 2020, the largest drop in 80 years. More importantly, the severity of the world situation in the face of the pandemic has the potential to erase the gains of years of poverty eradication efforts. While COVID-19 triggered the trend reversal, its effects have been intensified by armed conflict in some countries and the growing impact of climate change worldwide.⁶⁹

The pandemic-induced economic slowdown may have a lasting impact on international investment levels, remittances, and the labor force skills and overall health of millions of people who are now unemployed, as well as on learning outcomes (affected by school closures and the adaptation of educational practices, such as online courses) and supply chains.⁷⁰ World leaders, governments, international institutions such as the World Bank, celebrities, NGOs, and private individuals are fighting to prevent COVID-19 and its consequences from reversing efforts to eradicate poverty.⁷¹

The Environmental Crisis

In the contemporary economy, almost any imagined good can be produced for mass consumption. These goods are frequently manufactured, processed, or assembled in distant countries using parts from several other countries, and once ready, they are shipped to stores around the world. This production process uses raw materials, labor (often cheap labor in developing countries), and energy, including the energy used for transportation. While this process creates affordable goods for mass consumption, it has undesirable consequences. In addition to contributing to poverty and inequality, this system also does harm to the environment. As factories burn fossil fuel to generate energy and power machinery, greenhouse gases (GHG) are emitted into the atmosphere. The Intergovernmental Panel on Climate Change (IPCC) considers the cumulative release of GHG since the Industrial Revolution to be the main cause of climate change.⁷² In short, the environmental crisis is another unintended negative consequence of the market economy.

Literature on the possible ways to deal with the environmental crisis can be divided into two broad currents of thought. Some scholars propose that, in order to overcome the crisis, society must alter the mechanisms that generate it, and since the crisis is caused by the unwanted consequences of industrial production, these scholars argue for degrowth, a decrease in economic production and consumption levels. That is, to these scholars, slowing down industrial production and facing economic degrowth is the only way forward if the world hopes to counteract climate change.⁷³

Another group of scholars claims that the mechanisms that generate the crisis may be altered through sustainable development. These scholars argue that it is possible to combine economic growth and environmental quality as long as the production process is improved through innovation, technology development, and regulatory intervention. The UN, the EU, and many governments support this argument. The prevalent idea is that as countries increase production efficiency through the development of green technology, global society may overcome the environmental crisis.⁷⁴

For a long time, the unwanted consequences of industrial production have been largely neglected. This is due in part to skepticism about climate change,⁷⁵ but mostly to the costs associated with addressing them. In economic terms, the level of industrial output in a market is determined by supply and demand. Factories produce goods to meet the needs and wants of consumers. Traditionally, factories have incorporated the private costs of production into their prices. These costs include, for example, raw materials, labor, rent, utilities, and depreciation. However, these factories have not typically included the social costs of production into their prices. The social costs of production include costs related to social and environmental requirements, such as occupational injuries; deforestation; air, water, and land pollution; acid rain; and GHG emissions.

Because environmental costs have not been incorporated into the price of goods, they have been split across many individuals. Commonly, it is not consumers who bear the burden of a product’s highest environmental costs. For example, the Texas Gulf Coast is home to six oil refineries. Oil refined at these plants fuels the vehicles of millions of consumers across America. In addition to refining oil, these refineries are the country’s largest polluters of benzene, a chemical compound known to cause various forms of cancer. Individuals who live in the vicinity of these plants and breathe the benzene-polluted air pay some high costs. They are more likely to develop forms of cancer associated with exposure to benzene than individuals that live further away from the plants.⁷⁶ So, the individuals who live near these refineries pay the highest environmental costs, while the benefits of cheap gas are spread among millions of American consumers. If the environmental costs of production were included in the price of gas, it would be much more expensive.

When only the private costs of production are added to a good’s price, the market reaches one price; however, the inclusion of social and environmental costs shifts this price. The difference between price one, which does not consider social costs, and price two, which adds them to the final price, demonstrates the unwanted consequences of production, commonly referred to as environmental externalities. As fewer consumers are willing to pay the full price for a product, sales of the product decrease. As sales decrease, production levels also decrease. Consistently lower sales and reduced production levels tend to generate unemployment.⁷⁷

To mitigate and adapt to the consequences of the environmental crisis, the UN has promoted Sustainable Development Goals.⁷⁸ The European Union (EU) has worked to develop a stringent body of environmental policies since the late 1980s,⁷⁹ and Korea and Japan have adopted similar policies.⁸⁰ The United States took some relevant steps toward sustainable development during the Obama administration (2008–2016), scaled back those efforts during the Trump years⁸¹ (2016–2020), and has resumed efforts to meet sustainable development goals under Biden. (2020–present).

1. Reused from Chapter 16 of Rom, Mark, Hidaka, Masaki, & Bzostek Walker, Rachel. (2022). Introduction to Political Science. OpenStax. https://openstax.org/details/books/introduction-political-science under CC-BY 4.0 license. Access for free at https://openstax.org ↑