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Nation States, Capitalism and theCrisisDavid Soskice asks whether and howcomparative political economy might help usunderstand the present crisisNumerous questions pose themselves forpolitical economists about the crisis – enough(never waste a good crisis) to keep PhDsengaged for a generation. But in my view there aretwo big picture questions which modern comparativepolitical economy needs to answer. One is why theepicentre of the crisis was in Wall Street and the City ofLondon. The other is this: the crisis occurred as a resultof failures in the main regulatory frameworks – thefinancial and the macroeconomic – which govern muchof the workings of advanced economies. Why, in sharpcontrast to the 1930s, have these frameworks changedlittle since the crisis? These questions raise majorissues for our understanding of modern capitalismand its relation to the state, as well as the likelihood ofanother crisis. Marxism offers little guidance – otherthan alerting us to the importance to the state of thosedynamic sectors in which a national economy hascomparative advantage.1. Why Wall Street and the City?The modern ‘varieties of capitalism’ literature seeksto explain differences in the comparative sectoraladvantages across the different advanced economies.In particular it highlights national differences in theinstitutional framework in which companies operate,notably governing labour markets, industrial relationsand career structures, educational, training andinnovation systems, and corporate governancesystems and how companies are organised.Liberal market economies like the US and UK havea ‘comparative institutional advantage’ in economicsectors which require both employees and companiesto engage in high risk radical innovation – a hallmarkof Wall Street and the City in the last two decades.Institutional preconditions are flexible labour markets,an education and training system with a strongemphasis on high level general education, companieswith top down management enabling rapid movementof resources, and a sharp corporate governancesystem to enforce profitability. These institutionscomplement each other in the liberal market world ofthe Anglo-Saxon economies, Ireland and Israel.But the varieties literature doesn’t go the whole way.Why are there no great high-risk financial centresin Canada or New Zealand, or Ireland or Israel? Arapidly growing area bridging political economy andeconomics is the political economy of geography.High-risk activities need agglomerations of companies,so that labour mobility is neither too costly to employeeor to company. Agglomerations are a key concept ineconomic geography. They force us into history andpath-dependency and tipping points: at some momentin history, the network economies of Wall Street or theCity became too attractive to new entrants and existinghigh level financial institutions for them to seek to locateelsewhere. A tipping point had been passed, and theircurrent dominance had become path-dependent.14
2. The key regulatory systems: why so littlechange post-crisis?Turn to the second question. The regulatory system mostimplicated in the crisis is that governing the operation offinancial markets and leveraged financial institutions. Thenext most implicated is the macroeconomic regulatorysystem, governing the management of aggregate demandthrough fiscal and monetary policy to control inflation andunemployment.The financial regulatory system operates de facto ona national basis monitoring major financial institutionsoperating within the national territory, deciding on detailedrules and interpretations governing inter alia the definitionof riskiness of assets, the computation of capital, on andoff balance sheet items and so on; it also in principle takesa view of the systemic risks which may arise within thenational financial system. There is some agreement thatthese systems failed in the UK and the US. The Americanregulatory system, with the British system not far behind,allowed major investment banks to move to very highlevels of leverage; if off balance-sheet items were correctlyassessed and if dubious accounting practices corrected,the leverage levels were higher still. At very high leveragethe possibility of bankruptcy given a major adverseexpectational shift is non-negligible. Moreover, theseleverage levels took the assessment of rating agencies andcredit default swaps (‘insurance’ against loan and otherdefaults) at their face value. This made sense if systemicrisk was discounted; but the relevant UK and US regulatoryagencies (de facto, the SEC, the Fed, the FSA and theBank of England) did not pick this up in a timely way; theBIS in Basel was more sensitive to this possibility but it hadlittle influence.As is well known these high leverage levels were massivelyreinforced by global imbalances. External US/UK deficitsallowed private sector dissaving, generating a highdemand for risky assets (loans to households); and thecorresponding net saving in the exporting countrieswas invested in the US and the UK and enabled thefinancing of the risky assets – the other side of the coin.Global imbalances were permitted by the system ofmacroeconomic regulation. ‘Inflation targeting’ summarisesthe system widely adopted in the last two decades ona nation-by-nation basis, involving independent centralbanks using interest rates to keep inflation at a target levelin the framework of a New Keynesian macroeconomicmodel. International coordination plays no role ininflation targeting; there are no requirements on externalimbalances; indeed, external imbalances and the realexchange rate are technically jointly determined byaggregate demand – for example a tough fiscal policy,reducing aggregate demand, implies ceteris paribus anexternal surplus. It contrasts to Bretton Woods, wherefundamental disequilibria had to be corrected.Thus the key national financial regulatory systems allowedmajor financial institutions extraordinarily high leverageand did not have the means to monitor the possibility ofsystemic collapse in the US and the UK. And the nationalsystems of macroeconomic regulation – in the exportingcountries (Germany and Northern Europe in EMU andJapan, as well of course as China with more dirigistemacroeconomic management) – allowed the developmentof (massive) global imbalances which ratcheted up thispossibility. But since the crisis the inflation targetingsystems have hardly changed. And while there hasbeen tightening of banking rules, this has taken place in“The answer webelieve lies inrethinking therelation of nationalgovernments andcapitalism.”Martin Wolf’s terms ‘within the pre-existing intellectual andinstitutional framework’; in particular, national regulatorsremain responsible for interpretation, monitoring andsanctioning.The answer we believe lies in rethinking the relation ofnational governments and capitalism, in both the advancedworld and in developmental states like China. Nationalgovernments are deeply concerned about promoting highvalue added economic sectors, especially those where thevalue added comes from human capital. These sectors,in a ‘knowledge economy’ world, provide the drivers fornational innovation, for links between universities and theprivate sector and for higher-level education and training,as well as well-paid employment and tax revenue. Thistypically does not reflect partisan considerations. Werethese sectors the same across the different advancedcountries, one might have expected a common publicor private supranational regulatory system. But differentvarieties of capitalism generate comparative advantagesfor different high value added sectors: as we have seen,high risk high innovation financial sectors are located inLiberal Market Economies (as well as many other businessservice sectors, commercial law, and also biotech,blockbuster software, and radical innovation in electronics).It is no surprise that the US and the UK should want toretain control of financial regulatory systems to ensurethat risk-taking and innovation is not stifled; this was asmuch Clinton and Blair’s concern as it was that of Bush orThatcher – who started much of this off with the Big Bang.By contrast, the comparative advantage of German orScandinavian capitalism is in the export of a great rangeof highly specialised goods and services, benefitting fromstrong vocational training and technology transfer as wellas experienced and cooperative workforces, underpinnedby block shareholding. In part because human capitalin these high quality sectors is deep and specific, soneeds to be used to the full in exporting; in part becausethere are typically strong positive externalities to trainingand innovation systems from increased exports; in partbecause a tight fiscal policy constrains wage demandsin the public sector from undermining restraint of exportsector unions: these countries, as well as Japan and Chinafor similar reasons, want no constraints on their exportsthrough macroeconomic regulatory rules pressuring themto expand consumer demand.Analysing the modern world requires understanding thedeep concerns of the governments of advanced nationsfor their high value added sectors, hence their concern toretain control of relevant regulatory systems. Their successin doing so, as in nurturing their high value added sectors,may explain why – despite three decades of globalisation –these governments dominate world politics.This article is based on work with Peter A Hall and TorbenIversen, who both teach Government at Harvard. To readmore see Peter A Hall and David Soskice, Varieties ofCapitalism (OUP 2001). Peter Hall completed the MPhil inPolitics at Balliol in 1974.David SoskiceResearch Professor of Comparative Political Economy,Senior Research Fellow, Nuffield College15
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