I thought it would be useful to clarify the economic theory that lies behind my parable on the global economy. The book covers these issues at length, so I thought that the links with the parable, coming at the end as it does, would be obvious to the reader. Obviously this need not be the case for those who haven't read the book and encounter the parable on its own. So at the risk of explaining the obvious, here we go.
The parable identifies three problems that call for collective action and exemplify one the central arguments in the book that markets and the state are complements.
- There is common-pool problem that markets cannot solve, in the form of incentives to overfish and deplete a commonly shared resource. The community's "solution" is to create a cooperative that restricts how many fish each individual fisherman is allowed to catch. This is a stand-in for all kinds of market failures (externalities, asymmetric information, etc.) that require public action.
- Reducing the transaction costs associated with long-distance trade requires the building of an appropriate infrastructure (a paved road). In the parable, this is accomplished through the organization of a work brigade that cuts through the forest separating the two villages.
- Trade creates some losers and therefore the potential of social conflict. The village responds by strengthening its existing mechanisms of redistribution and compensation (village feast).
The paved road enables much higher volumes of trade, but it also creates two additional problems.
- It aggravates an existing market failure. Foreigners, who are not subject to the same regulations as the locals, can now come and fish in the lake disregarding the threat to the sustainability of the fish stock. I have in mind here the undermining of domestic regulations (in health and safety, finance, or labor markets) by competition that originates from jurisdictions with different regulations. As formulated in the parable, this is strictly an economic efficiency problem, although it could have distributional and social implications as well.
- It aggravates a social problem. The greater ease with which trade can be undertaken and producers can move in and out of the village makes it more difficult to sustain the community's prevailing social bargain, namely that it is OK for fishermen to get rich as long as others are not being left too far behind. Fishermen become less likely to contribute towards compensation at the village feast, both because it is now easier for them to evade the requirements and because they can (with some reason) complain about the burden of the tax on their ability to compete with outsiders.
These issues generate conflict between different groups in society. The parable suggests that internal debate and deliberation can produce a reasonable a compromise. The compromise does not entail the blocking of trade or high barriers, as some groups want. But it does entail accepting some transaction costs on external trade and a departure from complete free trade (what I call "hyperglobalization" in the book).
Two further notes on this outcome. First, economic purists can complain that my "reasonable" solution is not the first best remedy to the identified problems. There may be better targeted policies to counter the efficiency and distributional problems highlighted in my parable. Trade interventions are rarely ever first-best.
Well yes, but as Avinash Dixit once wrote, the world is always second-best at best. It would be little comfort to the villagers to be told that they should resort to lump sum taxation, non-linear income taxes, or allocating property rights over the fish stock – when the practical implementability of such potentially more efficient solutions remains unclear. Chapter 6 of my book discusses in detail how thinking along first-best lines has led the world economy astray.
Second, trade enthusiasts will complain that if each nation ("village") is left free to enact its own trade policies, they will disregard the effects on other nations and the world economy as a whole will slide into protectionism. The fable is in part a counter-argument to this. When openness to trade raises overall national income, a properly structured political process should not have an anti-trade bias to begin with. And allowing greater "policy space" to individual nations will in fact make it easier to uphold the social bargains that enable openness to trade. A (small) deviation from the ideal of complete free trade (hyperglobalization) is a small price to pay for this. This argument is developed at length in the book, and the fable is meant to simply exemplify it.
This is not to say that there are no spillovers across borders. A country's trade restriction may worsen other country's terms of trade. So there is certainly room for multilateralism a la GATT. But I argue in the book for a "thin" version of multilateralism – along Bretton Woods lines -- that does not make a fetish out of minimizing any and all transaction costs to trade.