Sunday, August 17, 2008

The End of American Hegemony?

There was an interesting issue raised in the economics blogosphere last week: the end of American hegemony. Nouriel Roubini started it off with his posting "The Decline of the American Empire" where--in addition to the much ballyhooed argument that U.S. foreign policy has been misused in recent years--he noted several economic developments that point to a loss of U.S. influence. The first is the rise of other economic powers:
[R]egardless of mistaken US policies the rise of other economic and financial powers – the rise of China, the recent resurgence of Russia, the process of economic and political integration in the European Union, the emergence of India, and the rise of other regional powers such as Brazil, South Africa and Iran – implies that the relative economic, financial and geopolitical power of the US will be reduced over time.
The second and more important development, according to Roubini, is the fact that the United States has been making poor choices in economic policy:
[T]he US squandered its economic and financial power by running reckless economic policies, especially its twin fiscal and current account deficits...

The trouble with these twin deficits is multi-fold. First, superpowers and empires - like the British Empire at its peak - tend to be net lenders – i.e run current account surpluses – and be net creditors, not net debtors; The decline of the British Empire started in World War II when the British fiscal deficits in the war and the current account deficits turned that empire into a net borrower and a net debtor both in its public debt and external debt. That financial switch into an external debtor and borrower position was also the reason for the decline of the British pound as the leading reserve currency. And the British twin deficits were being financed by a rising economic and financial power that was a net lender and a net creditor, the US.

Second, the last time the US was running large twin deficits in the 1980s the main financiers of these deficits were the friends and allies of the US, i.e Japan, Germany and Europe as the US external deficit was against these economies. Today instead the economic powers financing the US twin deficits are the strategic rivals of the US – China and Russia – and unstable petro-states, i.e Saudi Arabia, the Gulf States and other shaky petro-states. This system of vendor financing – with these US creditors providing both the goods being imported and the financing of such deficits – has led to a balance of financial terror: if these creditors were to pull the plug on the financing of the US twin deficits the dollar would collapse and US interest rates would go through the roof.

Third, while it is unlikely that China, Russia and other powers would suddenly pull the rug from under the US feet – as such action would lead to a sharp appreciation of their currency and negatively affect their export led growth model – relying excessively on the kindness of strangers – especially that of your strategic rivals – is extremely risky. Since almost 100 percent of all US fiscal deficits since 2001 have been financed by non-residents... by now the total stock of US Treasuries held by non-residents is getting close to 60 percent... This change makes the US vulnerable to such rivals using the financial terror weapon – dumping US assets and or reduicing their financing of the US twin deficits – in situations of geostrategic tension.

It is worth noting that some observes believe that 'geostrategic tensions' were behind the U.S. government's bail out of Fannie and Freddie. As reported by Bloomberg, Asian investors had pressured--some would say blackmailed--Treasury Secretary Hank Paulson to bolster these institutions. The key point, though, of the above paragraphs is that Americans have themselves largely to blame should this decline of American hegemony take place.

The next day Brad Sester followed up on this issue with his post "The Changing Balance of Global Financial Power." In it, Sester notes that democratic governments are increasingly receiving their funding from authoritarian governments. He provides some interesting graphs that show how the foreign assets of the authoritarian governments now exceed and are growing faster than those of the democratic governments. He concludes with the following:
One thing is clear: the world’s biggest financial powers are no longer the world’s large democracies. A gathering of the countries that matter for global economic coordination will no longer be a gathering of the leaders of the world’s big democracies. Coordination among the large democracies was never easy — and likely will only get harder as additional countries have to be brought in.
A key implication of Sester's posting is that America's influence is on the decline. Of course, these observers are not the first ones to make the case of America's decline from an economic perspective. For example, Niall Ferguson said the following in the Financial Times earlier this year:
Future historians will look back on the current decade as a turning point comparable with that of the Seventies. No, not the 1970s. This is not going to be another piece pointing out the coincidence of an unpopular Republican president, soaring oil prices, a sagging dollar and an unwinnable faraway war. I am talking about the 1870s.

[...]

This is the story of how an over-extended empire sought to cope with an external debt crisis by selling off revenue streams to foreign investors. The empire that suffered these setbacks in the 1870s was the Ottoman empire. Today it is the US.
A key story, then, that emerges from these pieces is that America's imminent decline stems in large part from its economic profligacy. These authors are spot on regarding America's spending and saving problems, but it is not clear to me that these problems imply anything more than a temporary dip in America's hegemony status. Yes, there are huge global economic imbalances that need to be worked out, but this does not mean the fundamentals that have historically made the U.S. so economically dynamic--relatively good institutions, a strong entrepreneurial spirit, and a culture of ideas and innovation--have structurally changed. If anything, the working out of the global economic imbalances should present more problems for the China and Indias of the world where institutions are less secure and the potential for social distress is greater. Moreover, the very emergence of these new economic powers is dependent on the global public goods provided by the United States. One wonders how robust their growing influence would be in the absence of such global public goods. Roubini concedes there is uncertainty on this point:
Whether the decline of an hegemonic power providing global public goods – security, free trade, freer mobility of capital and people, inducements to free markets and democracy, better environment, peace – will lead to a more stable world with many powers multilaterally cooperating on these global economic, financial and geopolitical issues; or whether the absence of such stable hegemonic power will lead to a more unstable world characterized by conflicts – economic, political and even military – among traditional nation states, great powers and non-traditional actors is an open and difficult issue.
Nothing, of course, is certain including America's hegemony status. I, however, am just not convinced that the past 7 or so years of economic profligacy is enough to undermine the United States's superpower status.

Update: Stormy comments on this issue over at Angry Bear.

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