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Averting a New Depression and
protecting the welfare state: The New
Post- WW II World Economic Order
Embedded liberalism, International
Institutions and Hegemonic Power
“If goods don’t cross borders, soldiers will”
Today’s agenda: Markets are global, politics
are local. Can the two be reconciled?
• Review: the welfare state, tendency toward economic nationalism,
embedded liberalism, the collective action problem, and the need
for a leader to make liberalism work
• The United States as a candidate for hegemonic leadership
– Able but unwilling to lead in the 1930s
• International Institutions as an alternative to hegemony?
– IMF
– World Bank
– GATT (WTO)
• Institutions not enough: the requirement for a hegemonic leader
• Why the U.S. decided to take the lead
• The consequences of leadership and institutions for the world
economy
Keynes repair of classical liberalism
• Theory of macroeconomics grew out of the Great
Depression
• Classical liberal models built on assumptions of
individual behavior (rationality)
• This might work for individuals but not for whole
economies
• Economic stability is not assured through market
forces
• Political stability requires state intervention to
achieve economic stability
First Modification:The welfare state
and aggregate demand
• Social insurance: permits those not working
to create demand in the economy
• Governments provide bank guarantees to
encourage savings and investment
• The government itself creates demand
• Government intervenes in the “trough” of the
business cycle to take over financial
institutions and even industry
The New Deal in the United States: Domestic
Embedded Liberalism + regulation
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WPA
Social Security
Minimum Wage
Banking regulations
FDIC, Glass-Steegal Act
SEC
WPA employed Artists!
But Free Trade tends to undermine
these new roles for the state
• Free trade and comparative advantage demand
that inefficient industries should fail and
employment should be left to the market
• Employment will fluctuate with supply and
demand for labor
• For Liberals, too much state intervention to
create demand does not allow the free market to
work properly: “tax and spend” reduce money
available for investment—governments should
“reduce taxes” to create aggregate demand
Leading to the demise of democracy
• Democracy becomes less appealing than
dictatorship
• when democracy fails to deliver the economic
goods, people begin to doubt its value.
The Great Depression showed that the classical liberal
response was too risky for governments
Not only was democracy endangered and
destroyed, but all states closed their economies
Dominant belief after WW II: Dictatorship
+ Protectionism leads to war
• beliefs about the economic causes of war.
Protectionism
Belief in
Economic
Nationalism
Trade Wars
Backlash against
democracy
Totalitarianism
International
Economic
fragmentation
War
Militarism
Expansion
…and Free Trade leads to Peace
Raises
price of
aggression
Free Trade
Comparative
Advantage
Global
Interdepe
ndence
Global
Prosperity
Peace
Prosperous American
Economy
To preserve the welfare state and preserve peace, the
international liberal economy would need to be
discarded or repaired
• Discarding Liberalism was not an option
• What kind of repair was needed: embedded
Liberalism
• But how to achieve it?
– Hegemonic leadership
– International institutions
What kind of repair was needed:
Embedded Liberalism
• Transplant from the simplest notions of
democracy : no long-term winners and losers
• Limited liberalism: open trade but allowing for
government intervention to stimulate the
economy and to maintain the welfare state
And how to get it: Hegemonic Power to the Rescue
• overcome collective action problems
• to help states keep markets open AND protect
citizens
– Credit ease balance of payments deficits
– Liquidity: counter-cyclical lending  prop up the
welfare state
– discount lending in crisis  maintain welfare state
Before the Depression, the US had the capability but not the
willingness to provide these resources to the international
economy
• Why?
Many believed the collapse of liberalism, depression
and war were caused by the absence of a hegemon
• Was there an alternative?
Keynes believed that international
institutions could take on this task
• in the absence of supranational institutions of
governance, the international economy had
an even more pronounced bias toward
deflation and instability than national
governments
• International institutions were needed to
protect the welfare state
The architects of global governance:
Keynes and White
The Institutional Mission: Embed
Liberalism!
• Resolving the “dilemma between internal and
external stability.”
• Intergovernmental collaboration to facilitate
balance-of-payments equilibrium
• Multilateralism in trade and finance based on
domestic intervention to achieve full
employment
• The world could have its cake and eat it too!
1944 UN Monetary and Financial Conference.
Bretton Woods, New Hampshire,
"if goods can't cross borders, soldiers will."
Conference agenda: The problem of
exchange rates
• ↑imports +↓exports  trade deficit  need
to pay up  deplete reserves  ↓
confidence in currency value ↓ currency value
 unstable trade (bad for trading system)
or…..
What you need for free trade:
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Fixed Exchange Rates
Currency convertibility
But No more Gold Standard!!!
There would be Fluctuating exchange rates in
the absence of the gold standard
• Roadblock to Free Trade
At Bretton Woods, the IMF was
created
International Governance of Public
Finance
• A new Gold Standard?
• Not exactly. It was called the “gold exchange
standard”
• The IMF was a watchdog: to ensure the
members did not change their exchange rates
• If they got into trouble, the IMF would loan
them money to replenish reserves to pay for
imports
Fixed exchange rates with IMF as “lender of last resort,”
and provider of liquidity
• ↑imports +↓exports  trade deficit  need
to pay up  borrow from IMF  currency
stability  trade stability
How does it work?
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The Quota System
How a quota is determined
What you give
What you get
– voting rights in relation to your quota
– borrowing rights in relation to your quota
World Bank
The GATT: (WTO)
Main Principles of the GATT/WTO: All
promise not to defect from cooperation
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Multilateralism
Reciprocity
Exceptions
Development
Defect
(protectionism)
cooperate
The WTO as a solution to the problem of
cooperation for Free trade
Cooperate (free trade)
Defect (protectionism)
5, 5 carrots:
GATT and IMF assurances that if I
keep my market open even with
BOP deficits I will receive help for
my problems and assurance that
others will not cheat.
3,3 sticks
DSM raises the costs of defection
3,3
You keep your market open but if
I close mine, You report me to
the WTO for non-compliance and
we use the DSM. If I lose, I must
pay you compensation
1,1
We both close our markets; you close
yours, I retaliate, you retaliate, and so
on…..no more free trade. No access to
MFN, reciprocity, etc.
Problem with these governing institutions: The war had
weakened the economies of the industrial powers
The Devastation of War in Europe
Destruction in Europe
And the institutions were too weak to
solve collective action problems
• Inadequate IMF resources
• Inadequate World Bank resources
• GATT was only a set of rules