In political economy, politics comes first

Pure economic theory is about as useful to understanding economic policy as Newtonian physics is to understanding a bird in flight. The bird is subject to the same forces and constraints as, say, a stone of equivalent mass--but unlike a stone, a bird can change its own course. So with political economy. The starkest laws of economics--opportunity costs, the general propensity for diminishing marginal returns, the determination of outcomes by the mutually influencing strategies of players in games--always apply, but real-world agents often act in ways that the theory, as usually applied, does not quite predict.

Recent developments in Europe have brought this lesson home. For people of my generation, who remember the period between the fall of the Soviet empire and the fall of the Twin Towers with crystal clarity, the Washington consensus attained something of the status of divine write. Good governance may have been difficult to establish, but it was at once straightforward and persistent. All a government had to do was let the rule of law take hold, establish some private property rights, and hold some elections and, presto, you've reached the end of history.

In the past decade, each of these recommendations and a host of corollaries has been shown to be either vastly difficult than assumed or actively counterproductive. (To take just one example, international relations theorists now argue that although democratic countries are less likely to go to war among themselves, democratizing countries are much more bellicose than the run-of-the-mill authoritarian state. Think for a second what that implies for a democratizing PRC.) One measure of this shift is what I like to call the Friedman Index, which is a measure of the fraction of Serious People who take Tom Friedman seriously. By all indications, the Friedman Index is a trailing measure that peaked sometime around 2005. Among NYT columnists, it is Krugman, not Friedman, who now speaks for the professional elite of the East Coast, with the prominent exception of the current occupant of the Oval Office. And Krugman, for obvious reasons, is hardly in thrall to the quantitative mystique in which economists have clad themselves over the past generation.

Which draws us back to Ireland. Conventional political economists have sought to explain the Irish example by looking at past IMF interventions and focusing on the narrow (but important) questions of how such international institutions allow states to credibly bind themselves to necessary but draconian actions they would otherwise be unable to sustain. (See, for instance, The Monkey Cage.) But this analysis is badly misguided, since it ignores the rather obvious point that the states now threatened by financial contagion have options that the Asian currency crisis countries did not. European states are massively wealthier and more influential than Thailand or Indonesia; unlike Jakarta and Bangkok, Paris and Berlin can simply rewrite the rules to benefit the bulk of their citizens who are not international creditors.

Would they? I expect they will. An editorial from the Irish Times suggests why:

IT MAY seem strange to some that The Irish Times would ask whether this is what the men of 1916 died for: a bailout from the German chancellor with a few shillings of sympathy from the British chancellor on the side. There is the shame of it all. Having obtained our political independence from Britain to be the masters of our own affairs, we have now surrendered our sovereignty to the European Commission, the European Central Bank, and the International Monetary Fund. ... The Irish people do not need to be told that, especially for small nations, there is no such thing as absolute sovereignty. We know very well that we have made our independence more meaningful by sharing it with our European neighbours. We are not naive enough to think that this State ever can, or ever could, take large decisions in isolation from the rest of the world. What we do expect, however, is that those decisions will still be our own. A nation’s independence is defined by the choices it can make for itself.

I would not be surprised if the Irish government at some point in the next six months breaks its most recent commitments to Brussels and M. Strauss-Kahn. I fully expect that whatever "punishment" is meted out to Ireland to that transgression will be forgotten within a decade. Equally, I expect the eurozone to do what everyone believed was impossible as recently as seven or eight months ago: to shrink to the point where it is an actual optimal currency area, which is to say that it will probably be Germany, France, Benelux, and some German quasi-possessions on its borders (Austria, the Czech Republic, and Slovakia).

A social science that proceeds inductively from a limited wealth of experience will miss the really important shifts. Generalizing from the international arrangements that governed the world economy over the past sixty years to the actions we can expect influential actors to take in the next decade is wrong-headed. It is time, instead, to begin preparing both scholars and policymakers to be ready for a world in which defaults are policy tools, states reassert their primacy over economics, and protectionism is put back on the table.