Martcb007, If you have been following Prof. Rodrik's works, you will know his answer to your first question already: "state capitalism" does have diminishing returns. According to the second-best model, or "mercantilism" as it is called in this article, which Prof. Rodirk is a strong advocate of, the state is supposed to initiate a new round of reform to overcome the institutional limits. Industrial policy or whatever names we want to call it, does allow developing economies to catch up by handing out rents; this is predicted by the big push model as well. The question is what comes next and how to prevent it from turning into crony capitalism or a kleptocracy. We don't even need to talk about China; Japan and Korea are still far from being the liberal, transparent and deliberative democracy that we come to admire. The problem is not so much with the economics as with the politics. Politically, there is no or very little incentive for a new round of political and democratic reform, when the ruling party can reap so much benefit from and with the power of the state. As for your second question, developed countries do practice mercantilism in some capacity. The internet is the outcome of that (A&R is wrong about state capitalism is all about getting power). If that is extended to trade more generally, my guess would be intrastate or regional trade will replace part of the international trade. Mayhaps it will not be a bad thing.

Paul Krugman has been saying more or less the same thing couple years now. If they didn't listen then, they wouldn't listen now. It seems the Europeans are just going to keep throwing more money at the problem until it reaches critical mass. And then we have supernova.

What I don't understand is why are you so hung up on "spontaneous cooperative solution", as far as I know nothing is spontaneous, not in this parable. If one village setup a toll, the other could respond in kind, so you have tariffs that limit trade, and only then the shamen will realize the problem and setup a metting, or even an inland-coastal-village-cooperative. That's how a "village-level political decision-making" process or global governance begin to emerge. The point being, Rodrik seems to say, is that global governance should not govern for the sake of governance (or ideals of governance); rather it should govern according to the problems occurring in the villages, and if global governance does not provide a good solution to the problems, the villages would simply withdraw, not enter into the cooperative, and/or not play by the rules (like China and India). To extend the point, it is rather meaningless to have 155 nations in one place talking about what is the best free trade regime when free trade does not adress national problems (on occasion exacerbating them). Sometimes it make sense to have unilateral or bilateral actions.

I filled in the blanks when I read the parable. When the fishing village unilaterally setup a toll booth, the inland village would respond in a similar way (the social problems of the inland village are missing in this fable) and that would reduce benefits for both villages. Recognising the problem, the shamen from the two villages met with each other and discussed an optimal solution.