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8 Global Economic Integration and the Distribution of Housing Wealth Harvard Professor Dani Rodrik has for many years presented an important argument on the inescapable trilemma of the world economy, which he calls an “impossibility theorem.” According to him, global economic integration, national sovereignty, and democracy are mutually incompatible choices in ordering the world economy. It is only possible to combine any two of the three choices, but not all three together at the same time. Although his idea is quite simple, it helps us to think clearly using bold concepts to configure a complex reality. Making this reality work without undue stress requires what Rodrik advises are nuanced approaches. Rodrik’s argument has gained increasing significance in light of the Eurozone crisis of 2011 and the economic tensions that have emerged in the G20 world since the global financial tsunami in 2008. His most comprehensive statement is presented in his recent book (Rodrik 2011). Figure 8.1 is a picture reproduced from his study to illustrate the key features of his theorem. Deep economic integration Nation-state Democratic politics Bretton Woods compromise Global Federalism Golden Straitjacket THE POLITICAL TRILEMMA OF THE WORLD ECONOMY Figure 8.1 The political trilemma of the world economy 88 Conditions Affecting Growth and Innovation Deep economic integration, Rodrik emphasizes, means that most of the transaction costs that traders and financiers encounter in cross-border economic and financial transactions have to be eliminated. In other words, there must be one set of rules to govern all economic activities regardless of where they take place. The globalization that has occurred in the past 30 years has been accompanied by attempts to create, step by step, a common set of rules to reduce the transaction costs of cross-border transactions. For example, the General Agreement on Tariffs and Trade (GATT) was replaced by the World Trade Organization (WTO) in 1995 to promote deeper integration in trade and investments than envisaged under the GATT. The Basel Accords likewise attempt to create a global standard for banking regulation . Accounting standards is another area where the migration toward a common set of standards has been on-going. Nation-states, on the other hand, are a fundamental source of transaction costs for cross-border exchanges. They are the origins of sovereign risk, they cause regulatory discontinuities to appear at the national border, they render effective global regulation and supervision of financial institutions next to impossible, and they prevent the creation of a global lender of last resort. These specific transaction costs are the ultimate source of the malfunctioning of the global financial system. In a democratic society, the domestic demands of workers, employers, and various special or popular interests are not aligned with the needs of deep economic integration. These domestic demands are one of the reasons why nation-states create transaction costs at the border to thwart deeper economic integration. For example, they may prevent immigration of foreign nationals to protect the jobs of local workers, particularly unskilled workers, but also professionals. They may establish a variety of protectionist barriers to limit goods, services, and investments from crossing their border under the pretext of safe-guarding industries, jobs, health, safety, the environment, national security, public morality, and so on. They often go so far as to accuse other nations of engaging in unfair, anti-competitive, and dumping practices. Consequences of the Golden Straitjacket One option in addressing the trilemma is to maintain the nation-state’s sovereignty , but let it play second fiddle to the demands of the international Global Economic Integration and the Distribution of Housing Wealth 89 economy. Such a state will sacrifice domestic objectives in its pursuit of global economic integration. The nineteenth-century gold standard represents the classic historical case of what such a state has to do. However, the limitations that resulted from the currency union based on the gold standard leads Professor Rodrik to call this option the “golden straitjacket.” The collapse of the currency board system in Argentina in 2002 illustrates the inherent incompatibility of the currency board system with a democracy that had a propensity to incur fiscal deficits and public debts due to populist pressure. The experience of Hong Kong under the linked exchange rate system during the Asian financial crisis is particularly illuminating. In staying with the linked exchange rate, Hong Kong lived through a period of intense deflationary pressure. Between 1997 and 2003, the cumulative consumer price deflation was 11.6%, the cumulative GDP deflator deflation was 17.5...

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