How Much Freedom do Governments have in a Global Economy
Robert Skidelsky
Warwick Lecture | Thursday, September 28, 2000

It has become a cliché to say that governments have lost power to the global market. For the New Right this is a matter of some satisfaction: they like markets and they don’t like governments, or at least Big Government. To the Left, Old and New,who often talk as though global markets mean multinational corporations, it is a matter of regret. They don’t like markets, and they like Big Government. Although socialism is off the political agenda, the old Right-Left battle still rages. Both sides are increasingly defined by their attitude to globalisation.
Globalisation is doubly contested. People not only disagree about whether it is good or bad, but about what it means, or even whether it is all that new. It is clearly a process; and to my mind the least contentious way of talking about it is to say that it is a process of opening up hitherto closed national economies to market forces, which is expected to lead to a single global market. Globalisation, that is, is taken to mark the end of the epoch of closed economies and the dawn of the era of open economies. Political and economic frontiers no longer coincide. The term first started to be used at the end of the 1980s.
It must be admitted that the implied contrast between the eras of closed and open economies is a dramatic over-simplifcation.As a first approximation one might say that from the end of First World War to the 1970s, national economies were closed off from each other to a greater or lesser extent. The main instruments of closure were tariffs, import licenses, qualitative and quantitative quotas, preferential trading systems, overvalued exchange rates, capital and exchange controls, immigration controls. Like money, knowledge- of other places other conditions – was also much less fleet of foot than it is today. Reference groups tended to be national, not inter-national..Exchange controls limited foreign travel. Whenever there was a sterling crisis –and these were frequent –strict limits were imposed on how much money British holiday-makers could take abroad. In 1967 it was £15.
With barriers to freedom to export and import, to the the circulation of knowledge, and to foreign travel, governments could undertake whatever politico-economic experiments they wanted at home, constrained only –in democracies –by what their electorates would put up with.
Closure was never absolute, especially in the non-communist countries. Trade liberalisation continued steadily through successive GATT rounds, though it barely affected the developing countries. The leading European currencies became convertible on current account in 1959-60. . But the process of ‘opening up’ national economies accelerated explosively in the 1980s and 1990s, as a result of four main developments: The first was the repudiation of the ‘Latin American’ model of development, based on import substitution, which came in the wake of the debt crises of the 1980s. The second was the collapse of communism in 1989-91. The third was the liberalisation of capital accounts which accompanied the move to a single market in the EU. Finally, in the 1990s came the new Internet economy based on the revolution in microelectronics. Most dramatic of all has been the huge expansion in the scale and speed of international capital movements.
It is the mobility of capital which, above all, is said to have robbed governments of their former instruments of controls. ‘Portable tax’ bases limit the scope of tax, and hence social policy. International financial markets punish ‘unsound’ fiscal and monetary positions. Globalisation eats away at the power of states to shape national economies according to the preference of planners and voters. The exit door has simply opened too wide.
Advocates of globalisation argue that what governments lhave lost is simply the freedom to keep their countries poorer than they would otherwise be. However, critics might point to three disturbing implications:
First, openness is asymmetrical. . Capital is much more mobile than labour. So globalisation is likely to be on a pattern preferred by big business, though not necessarily at expense of workers’ interests.
Secondly, there is an asymmetry of power. . Globalisation is driven by the USA and institutions it dominates. Again, this is not necessarily against the interests of others.
Thirdly, there is a reduced scope for democracy. In Francis Fukuyama’s famous ‘end of history’ thesis the triumph of capitalism and of democracy go together. But on the face of it there seems to be a contradiction between market-driven globalisation and democratically driven demand for greater accountability. One may call this a conflict between ‘exit’ and ‘voice’. If the economy is controlled by markets, what is left for the voters to control? Foxhunting perhaps?
Let us concede, for the sake of argument, that governments are less dominating in economic life than they were, or seemed to be, twenty or thirty years ago. Two initial questions might then be asked. Is the decline of political control over economic life a good or a bad thing? And how did it come about? The answer to the second question will show that globalisation is not just a process, but part of a process which starts with the breakdown of the ideas and interests which supported the political economy of ‘closed’ economies. We will then be in a position to give at least a tenative answer to the final question: is the loss of political control over economic life irreversible, or can states acting , singly or in combination, turn the clock back?
One's views about how much control a government should have over economic life will depend first and foremost on the value one attaches to individual liberty. But it will also be influenced by two further considerations. What is it one believes that governments aim to achieve –in economic language, what is their maximand? And, even if we assume that their intentions are wholly benevolent, do they have the information necessary to achieve their goals?
In the older economics -the kind say that was taught in the 1950s and 1960s -it was assumed that the government wants to maximise social welfare. The actual form of the welfare function can be varied but generally it was thought to be a weighted or non-weighted sum of the individual utilities of members of society. In the Soviet command economy, in which markets were abolished, the government was entirely responsible for maximising social welfare. In market economies, this task was supposed to be shared, with the government seeking to correct market failures. The extent of its role depended on how pervasive or serious market failures were supposed to be, but generally in this kind of society government policy was thought of as a residual -making up the deficit in social welfare resulting from market transactions.
The task of economics, then, was to tell governments how they needed to arrange the system of taxes, subsidies, etc, to achieve the social welfare objective. The familiar applications were to welfare economics, macro-economics, and trade theory. The theory of the declining marginal utility of money, for example, suggested a substantial scope for redistributing wealth and income.
Notice this was not a theory about how governments behaved, nor even about how they ought to behave, but about how they needed to behave to solve the social planner’s problem. In this type of analysis the main problem facing governments is an information problem.
Many of the earlier analyses of government failure, for example . in macroeconomic policy, concentrated on information failures which, perhaps, might be remedied by bigger and better econometric models. Hayek's objection that government inevitably lacks the information necessary to achieve far-reaching economic and social aims was disregarded. Analytic doubts about whether a well-behaved social choice function existed at all were also sidelined.
I have outlined the benevolent despot theory of the state.
The formal economic study of how governments do actually behave awaited the arrival of the Public Choice school, though Adam Smith had said a lot about it, and, drawing on the experience of the Indian planning system, Jagdish Bhagwati had developed the theory of rent-seeking.
In public choice theory the picture of the social planner trying to maximise social welfare gives way to a picture of politicians and bureaucrats seeking to maximise their own welfare. Public choice theory tries to model the way governments actually behave. While welfare economics may be thought of as the theory of market failure, public choice economics is the theory of government failure.
In a democratic system (one in which governments have to get elected) political parties will act in such a way as to maximise the probability of their election. If the electoral situation is simple, with a single dimension (say a left-right continuum) and has voters with well-behaved preferences, there is a very simple form of utility function which the government or opposition aims to maximises. The Median Voter Theorem shows that a party seeking office will offer policies to maximise the utility of the median voter.
If the government cares about policy as well as about re-election it will seek to maximise a mixture of the median voter's preferences and its own preferences.
A further development of the same logic is to argue that governments seek that level of taxes which maximise their own revenues (welfare). This is the theory of the predatory state. Its most plausible application is to the command economies, where rents provide a living for the nomenklatura. But it might be argued that bureaucrats everywhere try to increase their budgets.
Notice that the common thread running through various types of public choice theory is that politicians and bureaucrats (whose aims might conflict with those of politicians) seek to maximise their own welfare, not the social welfare. Public choice theory is about the private utilities of power holders and seekers masquerading as the public interest. Politics is a spoils system, with the contenders fighting for the spoils of power.
It is a much more cynical (and almost certainly more realistic) view of government than the benevolent despot assumption. The implication is that politicians' welfare and the social welfare only accidentally coincide. For example, redistribution policies will not follow the law of diminishing marginal utility, but will redistribute from top and bottom to the median voter.
This analysis, together with Hayek's earlier critique, gained ground as an attempt to explain the growing evidence that governments were failing to achieve their ostensible economic and social aims.
One’s views about whether the economic enfeeblement of governments is good or bad, will be influenced by one’s assessment of the intentions and capacity of governments. If one believes that government is inherently predatory, any check on its ability to extract rents from the factors of production is a good thing. The more open economies are, the less the ability of governments will be to exploit these factors through predatory taxation. From this point of view, globalisation is a good thing.
If, at the other extreme, one views government as benevolent and believes that it has adequate information, then any checks to its ability to improve social welfare will be a bad thing. From this perspective globalisation is by no means unequivocally welfare improving.
Our second question is: what is it that has driven governments from the ‘commanding heights’ of the economy? The standard answer is: globalisation. But even a cursory attention to chronology shows that this view is seriously defective. No one talked about globalisation before the late 1980s. Yet the ability of governments to manage, plan, or regulate economic life had been seriously impaired before globalisation got going. Globalisation is as much a consequence, as a cause of declining government power.
Take four areas of policy.
1. Macro-management. Keynesian fine-tuning had been discredited in most developed economies by the late 1970s. Once inflation is anticipated, systematic Keynesian policy is ruled out. The parallel collapse of incomes policy also had nothing to do with globalisation. The obverse is also true: globalisation does not rule out the use of stimulatory fiscal policy in some circumstances, for example, in Japan in the 1990s, though the results are ambiguous.
2. Tax resistance is scarcely new. A rather famous example is the Boston Tea party which sparked the revolt against British rule in North America. In contemporary Britain, it dates from the time income tax started to bite at lower income levels in the late 1960s. Proposition 39 in California came in 197..? Tax-resistance was almost certainly one of the main causes of the domestically-generated inflation of the early 1970s, making it more difficult for governments to balance budgets at high levels of spending and fuelling wage demands. Cuts in top marginal rates of taxes also preceded globalisation.
3. Privatisation preceded globalisation. Publicly-owned industries were costing the government too much. British Steel wasn’t even competitive in the protected British economy. Privatisation was a way of getting rid of subsidies from the Exchequer.
4. The move to restrict social provision also started before globalisation. It was, of course, connected with the growth of tax resistance, also a perception that the welfare state was failing –at least in the USA which never had much of one, and in Britain. Extensive redistributionary taxation was rejected by electorates.
All these limits to government were being established before globalisation took off. There was a widespread perception, both at the elite and the popular level, that Keynesian social democracy was not working. Economists and political scientists, not all of them from the New Right, explained why this might be so; voters started to repudiate governments wedded to this model.
What was the relationship between these development and globalisation? The simple answer is that they made it easier for governments to open up their economies to global competition. Globalisation, that is, was partly driven by the failure of national planning. Once globalisation took hold, then it became much more difficult to return to national systems of political economy.
The retreat from big government did not happen at the same time or at the same speed everywhere. The collapse of the communist economies did not take place till 1990. In this case, and also in the case of Latin America, the OPEC price hikes of 1973-4, and 1979-81 and the demonstration effect of de-regulation in the United States and Britain, and the ‘economic miracles’ of East Asia undoubtedly played a part in undermining existing systems of national control. However, the main trigger to ‘opening up’ was the contradiction between borrowing large sums of money from abroad and trying to run closed economies at home, which resulted in a sequence of fiscal and currency crises throughout Latin America, Africa, Eastern Europe, and India in the decade of the 1980s.
The European Union offers a partial counter-example. The completion of the Single Market in the early 1990s and the start of the single currency in 1999 are the culmination of a much longer process of lowering trade barriers within the European Community. However, the drive to European Union can also be seen as an attempt to give Europe’s national governments, acting in concert, greater control of their external, and thus of their domestic, environments.
What are the limits on government policy imposed by globalisation per se?
In trade, .governments are free to do what they like, provided they don't sign up to WTO rules. But there are enormous opportunity costs to Protection. Governments remain free to make their countries poorer than they would otherwise be.
In taxation policy, governments remain free to tax immobile factors as much as they want, subject to domestic political constraints. Resistance to paying income tax partly explains the shift to consumption taxes. Where capital mobility is guaranteed, there is now an additional constraint on income and capital taxes. Where labour mobility is guaranteed (as in the EU) there is an external constraint on consumption taxes. In its drive for tax harmonisation the EU may be seen as a political cartel to prevent competition driving consumption taxes downwards.
As for capital movements, governments are free to impose both inward and outward controls, and some governments do so (Chile, Malaysia). However, there is an opportunity cost. Countries which impose capital controls will get less inward investment. IMF loans are also conditional on liberalising the capital account. However, with capital controls, IMF loans or guarantees are less likely to be needed. (India's experience in 1980s).
So the costs of 'unsound' policies in a globalised economy are punishment by investors, and foregone opportunities of trade and inward investment. The costs of globalisation itself may be extra frictional and structural unemployment, greater vulnerability to shocks, greater vulnerability to ‘contagion’ from financial crises, greater exposure to undesired cultural imports (e.g. pornography, drugs).
The conclusion of this discussion may be summed up as follows. Political control of economies has weakened more or less everywhere. Whether one regards that as good (welfare enhancing), or whether one thinks it has gone too far or should go further depends largely on what one thinks the functions of governments should be, what one thinks their capacity is , how risk-averse one thinks populations are, and how serious one thinks market failures are. Only part of the new constraints on government can be attributed to globalisation. Many of them had domestic origins. The emergence of these constraints on government freedom, though, made globalisation possible.
The above discussion raises an obvious question. Do politics or economics play the main role in producing any particular set of economic outcomes? The logic of governments or the logic of markets? Or, more realistically: how do politics and economics interact to produce economic results? There is no clear answer, but at least two traditions of trying to answer the question.
One answer , dating back to Adam Smith, holds that markets are the natural form of economic life. Margaret Thatcher was echoing it when she said: 'You can't buck the market'. In this tradition, the correct role of government is to facilitate the development of efficient markets, providing an appropriate political and legal infrastructure. This is the government role, for example, which the international institutions urge on the emerging and post-communist market economies.
The second answer, partly developed in response to Adam Smith and his followers, is that the market order –as opposed to the existence of particular markets - is artificial, and therefore has to be created by policy, even by force. So it is always contested. This tradition includes Marx, Polanyi, even Hayek, also all the great religions.
From these two traditions follow two views about the historical relationship between politics and markets.
For those for whom the market order expresses the general interest of all in improved welfare, politics is likely to be seen as the domain of selfish, or particular interests, i.e. of rent-seeking. It is only under special circumstances that the interests of rulers coincide with those of the people. Public choice theory is the formal expression of this perception.
Those who regard the market order as artificial tend to see the state as protector of wider interests of society against the market. This wider interest is usually defined in non-economic terms. It is not incompatible with markets; but market processes and outcomes have to be made consistent with other national, social, or moral aims. A market order, that is, has to be made socially acceptable. It is reflected in the current slogan of the French socialists: 'Yes to markets; no to a market society'.
Hayek doesn't fit readily into either camp, which is why he is interesting. He regards the market order as artificial, but nevertheless as the best order possible. It is an achievement of civilisation, which always has to be fought for against the prejudices of 'natural' man, which can be too readily stirred up against it.
Whichever view one takes, history suggests that politics trumps markets. If markets are natural to man, why was mankind so poor for so many thousands of years? One answer might be that scientific economics only started in the 18th century, and since then rulers and people have both understood much better how to increase wealth. But this can't be quite right, as, since the 18th century, we have had a number of very severe relapses from the market order: both fascist and communist economies were constructed in defiance of Adam Smith. This could only have happened had something been lacking in the economist's account of the world. We do not experience similar retrogressions in the natural order. These economic retrogressions were led by politics.
The main task of political economy is historical: to study those moments or conjunctures in which a change of economic system took place, and to try to say something about the causes which produced it. It will be found, I think, that in all cases these changes are initiated by ‘winning’ coalitions of interests, using the stock of available ideas. In other words, the relationship between state and markets is always mediated by interests and ideas.
It is hardly controversial that special interests, including those of rulers, shape state policy. Historians locate the origins of mercantile capitalism in the competitive character of the European state system of the 16th and 17th centuries. Monarchs needed merchants to generate the wealth to enable them to centralise the war-making power -that is, to destroy the feudal baronage. Similarly, the opening up of economies to market forces in the 19th century was deliberately instituted by the governments of late-comers to industrialism to thwart already powerful predators, like Britain. Such states borrowed from the practice of Britain, which was the most successful economy at the time, though they mistook some of these practices.
Producer interests can operate in either a liberal or protectionist direction. For example, Bismarck's tariff system of 1879 was based on a coalition of manufacturers and Junkers: the so-called coalition of iron and rye. The protectionist policy of the United States before the 1930s was governed by fear of competition from European manufactures; the switch to free trade from the 1930s onwards was led by export industries who saw a growing chance of sweeping European (and world) markets. There are many other examples.
We can take another instance from social policy. When only the rich paid taxes and had the vote, low-tax coalitions dominated electoral politics. With the advent of popular suffrage, it became possible to assemble high-tax coalitions. As income tax became a mass tax , tax resistance spread. Today it is impossible to assemble a high tax coalition. This is not the whole story. The structure of the tax system also plays a part. In Germany it has proved much more difficult to reform the welfare state than it was in the United States or Britain, because the benefits it provided (and continues to provide) were substantial for all classes. Because of the resistance to reform the German pension system now increasingly resembles a pyramid or Ponzi system whose solvency relies almost entirely on the number of new entrants keeping ahead of the number of claimants.
Most of this is consistent with public choice theory. The key concept is that of the minimal winning coalition. For example, Mondale failed to assemble a winning Protectionist coalition against Reagan in the 1980s. The Labour Party couldn’t assemble a high tax coalition in Britain in the same decade.
The pattern of interests in any particular society is much richer and more complex than the neo- Marxist picture of the conflict between multinational corporations and everyone else , with governments and the international agencies acting as the managing committee of big business. In modern times, and especially since the advent of democracy, all major shifts in economic policy have secured popular endorsement, even where they have not been precipitated by popular protest. Even before the manual working class had the vote, it was able to make its influence felt, in the repeal of the Corn Laws in 1846, in the revolutionary uprisings of 1848. An example from today’s Britain is the line-up on the issue of the Single European Currency. Big business is generally in favour, small business and popular feeling against. A government which tries to force British membership of the euro risks political extinction.
The influence of ideas is indirect, but still potent. Changes in economic ideas play a large part in shifting economic policy. For example, the Keynesian Revolution provided the ideological cement for an extremely powerful coalition of interests supporting state-management of relatively closed economies after the second world war. Public choice theory played a similar role in the politics of the New Right in the 1980s.
The ideas need not be economic. Attitudes to trade are heavily influenced by views of international relations: are they likely to be pacific or warlike? The present situation, in which there is no challenge to US global hegemony, is classically suited to a free trade order. (Compare Britain's position in the 19th century.) Economic policies also reflect views about the nature of the good society. Christian Socialism in the 19th century; social Catholicism in Germany today have played a large part in modifying the asperities of a market order.
I have left to one side the role of technology. This is one of the most intractable issues we encounter in assessing the sources of economic change. It is a cliché that globalisation today is driven by the huge fall in transport costs and by the 'new economy' of processes based on microelectronics. . The effect of both is to increase the amount of goods and services produced by an economy which are internationally tradable. To some extent this is even true of labour services. Cheap air transport enables Philippino sailors to be flown anywhere to man ships. It is frequently asserted that the Internet has put (or is putting) governments out of business, because what they used to control has been rendered invisible to the taxman or regulator.
It probably is true that government policies and social institutions adapt to the dominant technological paradigm, if only to keep nations competitive. But this is far from saying that electronic technology is bound to enlarge the area of economic freedom. The same technology which makes it easier for criminals to evade the law is also available to governments, and governments are always extremely inventive in matters of control, if in nothing else. The increase in crime is countered by CCTV cameras and biological advances in forensic science. Governments exchange information much more effectively now to deal with money laundering. Control through regulation can be more effective than control through ownership of industries or high tax and spending policies.
I have probably said enough to indicate the range of issues which needs to be addressed in trying to answer the question I set myself in this lecture.
Let me say that I am very much in favour of the globalised economy. But I also believe that there is no warrant, either theoretically or historically, for concluding that globalisation marks the end of the historical road.
States have a habit of bouncing back, singly or in combination. Four particular circumstances under which they might be able to do so can easily be imagined:
*Military challenges to the United States and its Allies. These might come from China or Russia, or from Islamic Fundamentalism. Or local bush fires may spread. The first world war developed from exactly one such bush fire. However, a military threat to the present order is unlikely to develop in the next twenty or thirty years.
*Another Great Depression. This is beyond the present bounds of consciousness. It doesn’t mean it can’t occur, if the conjuncture is sufficiently unfavourable.
*Ecological panics. This is familiar ground, and I won’t say any more about it.
*The revival of popular anti-capitalism. There have been premonitions of this, at Seattle and elsewhere.
Meanwhile, we can take precautions. The most important task of economists and politicians, acting together, is to work out a set of rules for the globalised economy, which makes sense both economically and politically, or at any rate does not cause a rupture between the two. We need better rules for money, trade, and exchange rates. But that is the subject for another lecture, indeed for a book.