The previous post noted the role of trade and the WTO in promoting a reduction in global inequality. The process of globalization, it argued, has allowed China to draw workers into its export industries, driving wages in China higher and reducing global inequality. The WTO acted as a "bonding mechanism," providing some assurance that the reform process in China would continue and that foreign investment in China would find export markets, reducing uncertainty. Empirical support for this proposition can be found here.
Those exports resulted in large trade surpluses, the counterpart of which were large capital account deficits — if you are exporting more goods than you are importing, you must, by definition, be importing more assets (claims) than foreigners are accumulating on you. Think of this process as the mother of all financial intermediation: current account surpluses in China reflected savings in excess of investment; capital account surpluses in the U.S. resulted from dissaving — domestic consumption and investment far exceeding domestic savings. From China's perspective, this made a lot of sense, particularly as its banks were weighted down by non-performing loans to state enterprises on the iron rice bowl. Channeling savings through state banks might have simply thrown good money after bad. Creating the conditions under which foreign capital would come in, bringing with it managerial and technological expertise, made for a far better deal.
But what if other countries tired of accumulating large trade deficits? What would prevent them from imposing trade protectionism or restrictions on this giant process of financial intermediation?
Well, as long as China adhered to its obligations under the WTO, other countries would be prevented from imposing trade restrictions. That was part of the deal to which all parties agreed. And, provided China remained a member in good standing of the IMF, other countries were precluded from imposing payment restrictions that would have the effect of trade barriers.
This underscores the fundamental nature of the IFIs. In effect, they are enforcement mechanisms for supporting cooperative agreements that allow all members to achieve better outcomes than would be attained acting alone. The folk theorem of game theory is that such agreements do indeed dominate non-cooperative equilibrium, but require institution support to monitor and enforce the agreement.
As I have written ad naseum, the global economy today faces some very large adjustment challenges. We have a collective interest in ensuring that the institutions of global governance have the legitimacy, credibility and effectiveness needed to get us through the New Age of Uncertainty.