Trilemma

Here’s something to think about as we celebrate our Independence Day: the “trilemma” between democratic government, free markets and the processes of globalization.

The notion of a “trilemma” has emerged among commentators on the evolving financial crisis in Europe. It refers to the apparently irreconcilable qualities of the three elements characterizing the modern nation-state.

Democratic governments are obliged to bend to the will of their constituencies. They will tend to be lax in maintaining fiscal discipline in order to deliver the goods their constituents expect. These goods, in the European context, include subsidized public health care, unemployment benefits, cheap food policies, among others.

Often, both political legitimacy and political support rest on the delivery of subsidized services. In Europe, for instance, many countries could not do without farm subsidies. Without these, farmers would not farm or food products will be too costly to be competitive.

Subsidized social and economic services provided by the modern state put a strain on the national budget, often forcing countries into large debts. Political logic inclines governments to defy the peril of huge indebtedness in order to maintain public support.

Free markets, on the other hand, function on an entirely different set of disciplines. When governments intervene too heavily in the operation of market forces, economies become dysfunctional. For instance, when governments try to control capital, the almost immediate response will be capital migration. It’s like trying to grasp sand in your hands: the tighter the grip, the more sand escapes from grasp.

We had a recent experience with this problem when our government tried to enforce lower fuel prices. When that happened, the domestic supply of fuel products thinned. Governments cannot freeze prices at the retail level if price at the source is uncontrolled. Retailers cannot be compelled to sell lower than wholesale prices. Otherwise, they become extinct.

Markets work best when they are ungoverned. Governments, however, are expected to govern the markets.

Then there is the matter of globalization, especially of the world’s financial system.

When, for instance, the Greek government borrows money, its need is supplied by an international consortium of banks. When a government allows its deficit to persist, it cannot finance that deficit from domestic sources alone. When a government begins to teeter on the brink of bankruptcy, the international banking system feels the hit. When it defaults on its payments, the financial implications of that event cannot be contained within the offending country’s borders.

What happened in Greece the past few months (and will probably happen in Hungary the next few weeks) results from the clash between democratic governments and free markets, domestic economies and the globalized economy. The Greek government tolerated a chronic deficit, financing it by borrowing from a consortium of European banks.

Because Greece was part of the European monetary union, it was able to borrow at the same low rate as, for instance, Germany borrowed. This reveals a critical flaw in the monetary union (the set of countries using a single currency). While risk (and therefore interest rate levels) is computed on the basis of the best managed economies (such as France and Germany), the most enthusiastic borrowers are the worst managed economies (such as Greece). A moral hazard is thus created: the badly governed economies are actually encouraged to borrow because of the cheaper rates.

The European Union, while it could set fiscal and monetary standards, could not enforce the same on its member governments. In Greece, for instance, the socialists constitute the ruling party. The constituents of the ruling party expect the government to protect their social benefits. Since the legitimacy of its rule depended on it, the ruling party went about protecting those benefits, until the whole thing became financially unsustainable and a debt crisis broke out.

When the Greek crisis broke out, the exchange value of the euro began to plunge. That affected all the other countries using the currency, diminishing the dollar value of their assets.

To complete the injustice, the best managed economies (such as Germany and France) must now finance the rescue package to prevent Greece from going under. The rest of the European Union must now pay for the fiscal irresponsibility of the Greeks.

The government in Athens, in turn, must face the scorn of its public for enforcing the austerity measures they need to do in order to return to financial viability. There is rioting in the streets of Athens. But if the rioters get their way, the entire euro zone will be plunged into a financial crisis even worse than what we saw two years ago.

Greece is, of course, an independent country. But that status of formal independence will not protect the Greeks from the conditions imposed by its neighbors in exchange for a bailout package. Nor will that status of independence protect the neighboring countries from the fiscal irresponsibility of the Greek state, given that state’s peculiar political contingencies.

All democratic governments are vulnerable to populist whim: to expectations that government absorbs costs for its citizens, dictate prices on free markets, cut taxes and yet maintain financial viability. Democratic government becomes an exasperating exercise.

All domestic economies are ultimately inseparable from the larger organism of the global economy. When one economy fails because governments cannot muster the democratic consensus required for proper fiscal management, the entire organism goes into a seizure.

Is the “trilemma” resolvable? The debate is still in progress.