Economic Paradigms and Democracy

Economic Paradigms and Democracy in the Age of Financial Globalization

Whether or not there exists a standard definition of the term Globalization, there is a broad agreement with the fact that the process of Globalization has had and continues to have profound impact on various aspects of human life. Globalization is not a new phenomenon for it has been a long-term gradual process of change, which affects every aspect of human life and being affected by the human enterprise, since the days of Columbus, and yet at the same time it is irregularly punctuated by episodes of dramatic change. Ever since the Columbian voyage initiated the process of intermingling of the continents of Europe and the Americas, Globalization has been influencing and reshaping every part of the world in all aspects of human life – social, cultural, economic, political, biological and ecological aspects.

In the recent past, there were two intense periods where the process of globalization induced dramatic changes across the world. The first wave happened in the late nineteenth century up to the First World War, which was characterized by extensive trade networks across various continents under European Colonialism. The second wave happened in the twentieth century, starting from the 1980s to the present day, characterized as free market Capitalism led by the phenomenal development of the financial markets, and called as the financialization phase of Globalization or simply Financial Globalization.

The aim of this article is to discuss the profound changes that were brought about by the second wave of Globalization, particularly in the context of the change induced by economic paradigms, and the consequent challenges to the political organization of the market economies. The beginning of the second wave of Globalization in the 1980s marked a distinct end to the global framework of economic organization between Nation States where the domestic political system was more or less sovereign to the people of the State. In fact, such a political arrangement multilaterally agreed upon at the Bretton Woods conference in 1944 provided impetus to the revival of the process of Globalization, which was disrupted by the two World Wars. Although, the scope of the revival was limited due to the Cold War, the economic success within the Western democracies based on this political architecture laid the foundation to further expansion and intensification of the process of Globalization.

The international political architecture based on the Bretton Woods agreement, which was ably supported by the sovereign Nation States and underpinned by the economic rationale of Keynesianism delivered the so-called ‘golden age of capitalism’, which collapsed during the 1970s. It was replaced by a unipolar world order underpinned by the economic rationale of Monetarism, which oversaw and supported the expansion and intensification of Globalization. The downfall of Communism and the end of the Cold War era opened the floodgates for the expansion and intensification of the process of Globalization outside the Western hemisphere. However, this process came at the cost of dismantling the very economic rationale that laid its foundation and undermining the political architecture that gave the impetus to its eventual evolution into the era that we refer to as the second wave of Globalization.

In the contemporary literature there have been numerous accounts on the impact of the second wave of Globalization on various dimensions of human endeavour at both the national and international context. In the following discussion, I would like to discuss the impact particularly in the domain of political representation and articulation brought about by the Monetarist economic paradigm, which replaced the Keynesian orthodoxy and advanced the second wave of Globalization. I will conclude with some specific examples of the impact from the recent experiences from Europe in the ongoing economic crisis.

The post Second World War period saw the replacement of the old economic orthodoxy of free market economic philosophy, i.e., laissez fair policies, with the Keynesian revolution. The revolution brought about a change in the political nature of the State. While both fiscal and monetary policies were informed by scientific research based on Keynesian economic theory, the State was very much seen as the implementer of those policies. The post-war political climate with systemic competition between Western capitalism and Soviet socialism also contributed to the winds of change in economic thinking, which in turn provided an economic rationale for the welfare State. The post war reconstruction aid from the US was instrumental, not by design, in experimenting with the economic policies of the Keynesian revolution in Europe. Not only did Keynesian policies demonstrate, based on the new theory of how even unproductive war expenditure could result in full employment and turn around ailing economies, it also provided the intellectual basis for the politics of social democracy, centered around the notion of Nation State, to bring about cooperation between the contending economic classes of labor and capital. Furthermore, with the advent of the Welfare State, there followed one of the most prosperous periods in European history, the so-called “Golden Age of Capitalism”.

“Not only did Keynesian policies demonstrate, based on the new theory of how even unproductive war expenditure could result in full employment and turn around ailing economies, it also provided the intellectual basis for the politics of social democracy, centered around the notion of Nation State, to bring about cooperation between the contending economic classes of labor and capital.” 

The uninterrupted growth in western economies created positive feedback between the politics of the Welfare State and Keynesian style economic management. The State was seen as the driver of the economy and its political nature was not questioned. More importantly, State action was not seen as detrimental to the interest of capitalists as long as Keynesian style class cooperation created investment climate conducive to private investment driven by profit. However, profit as the engine of growth slowed down with an ensuing profit squeeze in the 1970s and the limit to such cooperation began to emerge. The twin oil shocks (1973 and 1979) created inflationary pressures on already stagnating economies and questions were raised about the suitability of Keynesian policies, which by then had become conventional wisdom.

Economists led by Milton Friedman, in particular, began to question the established doctrine of Keynesianism by arguing that the economic policies of the State, fiscal and monetary policies in particular, were shown to distort the “expectations” of the economic agents and thus their supply decisions in the short-run, with no real impact on the macroeconomic level of output and employment in the long run. The second phase in the development of Friedman’s theory, often referred to as Monetarism Mark II, or the “New Classical School” led by Robert Lucas went further and demonstrated the ineffectiveness of monetary and fiscal policies by arguing that workers are endowed with rational expectations, which gives them the knowledge to know the exact consequences of such policies, would not alter their supply decisions, and hence there would be no impact of these policies for macroeconomic output and employment even in the short-run – this is the so called “policy ineffectiveness” argument.

The Monetarist counter-revolution had profound impact on the style of economic management. The Policy Ineffectiveness argument was used effectively to argue that rational economic agents would adjust their supply decisions even when the policy is simply announced by the monetary authority or the State. This allowed them to take the argument further and claim that given its political compulsions, the democratic State may not be in a position to stick to its monetary policy commitments. Hence, it was argued that the inconsistencies arising out of such a discretionary policy making of the State would only lead to negative impact on the sentiment of the investor and thereby affect their supply decisions. Thus, the Monetarist counter-revolution argued for an “independent” monetary authority, viz., the Central Bank that would conduct a rule-based monetary policy devoid of political interference from the State, and the process of delinking politics of the State from the conduct of the monetary policy was set in motion. 

The idea of an independent, objective, non-partisan and apolitical Central Bank targeting exclusively the inflation rate resonated well within the financial community and it was implemented in New Zealand, and soon was followed by many developed and developing countries. Thus the monetarist counterrevolution, like the Keynesian Revolution, redefined the role of the State in the economic sphere. In the pursuit of its ideal of a minimalist it took away from the state, as a first step, its control over monetary policy. However, fiscal policy still remained within the control of the State.

The Monetarist counter-revolution provided a perfect economic rationale for the conservative political ideology that advocated a minimalist state. Thus, the economics of the counter-revolution and the politics of Conservatism centered on the minimalist State aligned perfectly at the turn of the 1980s and the stage was set for the development of an unfettered financial sector around the globe. Fiscal policy was reined in to create a conducive tax climate to boost private investors’ sentiment vis-à-vis the financial markets. Even though the financial market went through a few “shocks” in the late 1980s and the 1990s, e.g, the 1987 one-day crash and the dotcom meltdown in 2000, the resilience of the modern financial sector was hailed as robust and its contribution to the overall prosperity of the economic expansion was applauded.

The Monetarist orthodoxy that dislodged the State from its monetary policy commitments using the logic of market sentiments got irrevocably locked into the very process in a self-referential way. The monetary policy was conducted by independent Central Banks, which supported the expansion of the financial sector that was to be overseen by an objective and scientific risk-rating mechanism. The Credit rating agencies provided such a service and gradually became the underwriters of risk for the entire financial system, including the Central Banks for their open market operations conducted within the ambit of monetary policy. It was believed that the apparently objective and scientific process of under writing risk provided a perfect barometer that gauged market sentiments. In this process, the logic of market sentiments became institutionalized via the risk-rating mechanism of the credit rating agencies. A pliable theory was restored from pre-Keynesian history to put in place a perfect self-referential setting by which an independent Central Bank was assumed to deliver consistent and credible monetary policies that supported the expansion of the financial sector, which was certified in turn as sound by a presumably objective process of risk- rating by the credit rating agencies. The result was massive financialization driven by financial innovations justified by this self-referential logic, which circumvented the State during the so-called ‘second wave of globalization’.

The Monetarist counter-revolution provided a perfect economic rationale for the conservative political ideology that advocated a minimalist state. Thus, the economics of the counter-revolution and the politics of Conservatism centered on the minimalist State aligned perfectly at the turn of the 1980s and the stage was set for the development of an unfettered financial sector around the globe.

During this expansion, it was understood that financial innovation, which improved the efficiency of the resource allocation function of the financial market, combined with the objective of a scientific underwriting process would improve the resilience of the overall financial system by sharing and distributing risk. A “competitive” market for the underwriting process developed and the efficiency of that market was considered vital for the resilience of the financial system and the overall economy. As the process of financialization deepened, the business and influence of the credit rating agencies grew in proportion and began to shape market sentiments, and their activities became integral to the functioning of the modern market economy.

The catastrophic collapse of the financial markets in 2008 and the ensuing economic crisis in the western economies did not affect the influence of either the credit rating agencies or the Monetarist orthodoxy. On the contrary, both the monetarist orthodoxy and the credit rating agencies that endorsed the rising level of systemic risk due to the financial innovation prior to the crisis have strengthened their position, which now seems politically unassailable despite the deepening of the crisis. In fact, using the current crisis the credit rating agencies have moved beyond rating the risk of private financial institutions to decisively underwrite the capacity of the Nation State in conducting its economic affairs. In fact, in the current crisis the rating agencies began to perform the role of “enforcer of discipline”, i e, disciplining the State from its extravagances via the rating of sovereign debt using the objective and scientific underwriting process, reinforcing the dominance of the monetarist orthodoxy and providing a great opportunity to implement its vision of a minimalist state. Their power does not merely stop at limiting the State and its agencies from borrowing from the market, it goes beyond the bond markets into the realm where it is beginning to reshape the politics of representative democracy in the conduct of the fiscal affairs of the state.

The economic rationale for delinking politics from fiscal affairs is to eliminate uncertainties concerning the conduct of economic policy in general and fiscal policy in particular. The discretionary nature of fiscal policy is questioned because it adversely affects investors’ expectations and market sentiments, and it is desirable to minimize uncertainties in the conduct of fiscal policy. This argument echoes the 1980s debate when monetary policy was delinked from the politics of the State on the ground that discretionary monetary policies induced inconsistencies in the investors’ expectations about future policy change, which, in turn, adversely affected market sentiments. Similarly, it is now argued that discretionary fiscal policy should be replaced by “fiscal policy rules”, which enhance transparency and consistency to sustain the stability of the markets.

Such a move to impose fiscal policy rules without discretion and separating it from “political pressures” is clearly articulated in the economic policy framework of the European Central Bank (ECB). The framework is succinctly described by the ECB as follows:

The (Maastricht) Treaty foresees three different modes of policy-making in the various fields of the European Monetary Union: (i) full transfer of competence to the Community level for monetary policy; (ii) rules-based coordination of fiscal policy; (iii) ‘soft’ coordination for other economic policies (ECB 2008: 22).

The European Central Bank (ECB), having reached the limit of maneuverability in terms of monetary policies, has broadened its remit by using its “technical” capacity to advise and influence both the formulation and conduct of fiscal and other structural policies in the member countries of the Eurozone. Drawing from the intellectual wisdom of the New Consensus Macroeconomics, a revised version of the Monetarist paradigm, the ECB has been pushing the so-called expansionary fiscal austerity or fiscal consolidation view in the conduct of fiscal policy to boost market sentiments in favor of the troubled countries, viz, Ireland, Italy, Greece, Portugal and Spain. Moreover, the ECB has also been using the soft coordination approach using both “peer pressure and support” and, more importantly, the logic of market sentiments to influence the structural policies in reforming the labour markets in the troubled countries.

Unsurprisingly, academic research under the influence of monetarist orthodoxy analyses the shortcomings of the diversity and wider political representation in government. Its recommendations articulate a case for reshaping institutions that govern decisions over public finances. Three types of fiscal institutions are prescribed: (1) Ex ante rules, such as constitutional limits on deficits, spending or taxes, (2) electoral rules fostering political accountability and competition, and (3) procedural rules for the budget process. Research on these types of fiscal institutions, a preoccupation in the 1990s, has produced voluminous literature, which in turn has provided the intellectual basis for the argument of conducting rule-based fiscal policy for minimizing the distortionary effects of discretionary policymaking by coalition governments in the west and developing countries.

Paradoxically, the economic paradigm founded on the logic of market sentiments that drove the Western economies to the brink of disaster has now become the economic rationale for the basis of economic recovery and for reforming the State. Furthermore, insulating policymaking of the State and its institutions from the so-called political pressures seems to be the emerging politics of this crisis and is being aggressively enforced through the veil of market sentiments. Thus it could result in delinking and disengaging the politics of representative democracy from the conduct of economic policies of the State, which is tantamount to undermining the very foundations of democracy. 

Srinivas Raghavendra The author is with the Department of Economics, J.E. Cairnes School of Business & Economics, National University of Ireland Galway, Ireland.