The New Economic Nationalism, Part 2: The New Great Game

Commentators often assume that relatively unfettered trade in goods and services and free movement of capital are givens, but the drive toward greater economic openness could now be undergoing a reversal, with profound implications for the global economy. This piece, picking up from where Part 1 left off, looks how different countries may adapt to this shift.

If current economic pressure lead to a shift to autarky, then the US, Europe and China are likely to find closed economies a realistic policy option, although for different reasons.

Splendid Isolation

Structurally, the US can function successfully as a closed economy.

The US remains the world’s largest economy, around 25% of global Gross Domestic Product (“GDP”) and almost twice the size of China, the second largest economy.

America’s economy has access to a large domestic market. It is less exposed to trade (around 15% of GDP) than other large economies.

Despite inequality in the distribution of income, America remains relatively wealthy, with per capita GDP of around US$50,000. American households have substantial net worth in excess of US$70 trillion, although down from a peak of over US$80 trillion before the financial crisis.

The US remains a major food producer with agriculture being a major industry. It is a net exporter of food, controlling almost half of world grain exports.

It is also rich in mineral resources. New technology has enabled America to access oil and natural gas, especially shale gas, from previously geological formations that were previously inaccessible. While US energy independence is not likely in the near term, increase in domestic energy production provides America with a significant advantage through competitive energy costs. Reduction in energy imports also reduces its reliance on foreign suppliers.

The US dollar remains the world’s reserve currency, with a market share of around 60% of global investments. The majority of global trade continues to be denominated in US dollars. The US borrows in its own currency, benefitting from a ready market for its securities, both domestically and internationally.

The US has favourable demographics. It has high population growth relative to other industrialized countries, which have below-replacement fertility rates. The US has higher levels of immigration, remaining a magnet for immigration attracting talent and additional labour.

Retreat from global integration is integral to the US dealing with its economic issues.

Key policies include maintaining low interest rates to reduce the cost of servicing debt allowing higher levels of borrowings to be sustained in the short run. Low rates and quantitative easing measures help devalue the US dollar, reducing the level of government debt, by decreasing its value in foreign currency terms.

A weaker US dollar boosts exports, reducing trade imbalances. A weaker dollar also reduces the cost base of domestic production encouraging a shift of production, manufacturing and assembly work back into the US. This should assist in creating the jobs needed to reduce unemployment.

Stronger growth and lower unemployment will assist in reducing the large US budget deficit.

A shift to a more closed economy is consistent with America’s natural isolationism, focused on aggressively protecting the nation’s economic self-interest and expanding US power and influence. As William G. Hyland, Deputy National Security Advisor to US President Gerald Ford and editor of Foreign Affairs magazine, noted: “protectionism is the ally of isolationism”.

European Desperation

Escalating sovereign debt and banking sector problems favour European introspection.

Individual European economies are modest in size relative to the US. But as a combined entity the European Union (“EU”), including the 17 member Euro-Zone who share a common currency, constitute over 25% of global GDP, making it the world’s largest economic unit.

The EU is a more open economy, being the world’s largest exporter and importer of good and services. But around 75% of its trade is within member nations, aided by removal of trade barriers and the common currency. For example, Germany, the EU’s largest economy and one of the world’s largest exporters, sells over 60% of its products within the common market, much of it to other Euro-Zone members. 

The EU is largely self-sufficient in food. As in the US, this is based, in part, on subsidies, minimum price schemes and trade restrictions which favour farmers.

The EU is a net energy importer, although mutually beneficial strategic agreements with Russia and other contiguous energy rich countries can provide security of supply. Significant potential natural gas finds in the Eastern Mediterranean Sea may emerge as a source of energy for Europe.

The need for greater integration to deal with its debt problems may be the catalyst for the shift to autarky.

As a single unit, the Euro-Zone’s current account is nearly balanced, its trade account has a small surplus, the overall fiscal deficit is modest and the aggregate level of public debt while high is manageable. But there are significant disparities between individual members of the Euro-Zone in terms of income levels, public finances, external account and debt levels. Greater integration would help resolve some of these variations.

However, it would necessitate a net wealth transfer from richer nations to weaker members. Stronger more creditworthy members would also have to underwrite the borrowings of weaker nations.  Currently, there is significant opposition to such joint and several liabilities, predictably from net lenders such as Germany, Finland and Netherlands.

But even without agreement on Euro-Zone bonds, de facto mutualisation of debt will take place. As more financing for weaker nations moves to official institutions like the European Central Bank and bailout funds, the commitment of stronger countries, especially Germany and France, increases. They implicitly assume the liabilities of weaker members of the Euro-Zone.

If it fragments, then the Euro-Zone will morph into a smaller version of the original, probably consisting of stronger core nations and a number of smaller entities. Nursing large losses and a significant diminution of wealth, survivors are likely to favour autarkical policies to restore economic health.

Irrespective of its policy choices, Europe faces a prolonged period of economic stagnation as it works off its debt burden and undertakes major structural changes to correct imbalances. During this transition, Europe will be forced to focus internally, husbanding savings and wealth needed to absorb the required large debt write-offs. Explicit or implicit capital controls and trade restrictions are natural policy measures to assist in this adjustment, marking a shift to a more closed economy.

Chinese Historicism

The Chinese mercantilist model is also increasingly problematic, as growth slows and its weaknesses emerge. China’s economy is largely closed, making it easier to adjust to the new environment.

China’s policy position is driven by the economic problems of its major trading partners. Given their lower levels of growth, exports to Europe and America can no longer drive Chinese growth. China will have to rely on domestic developments to drive the strong growth necessary to preserve social stability and the rule of the Communist party. An internal focus would assist China to undertake the rebalancing of its economy from one driven by exports and state directed debt financed investment to one with higher consumption.

China’s economic redirection may be driven by its enormous loss of wealth, from engagement with the West.

Before the financial crisis, the US purchased real goods and services from China, financing them with US dollar denominated I-O-Us with low rates of interest. China’s $3.2 trillion in foreign exchange reserves are invested, primarily in government bonds and other high quality securities denominated in US dollars, Euro and Yen.

These investments have lost value, through increasing default risk (as the issuer’s ratings are downgraded) and deliberate policies to engineer falls in the value of the foreign currency against the Rimini. Attempts by the Chinese to liquidate reserve assets would result in sharp falls in the value of the securities and a rise in the Rimini against the relevant currencies with large losses.

China has become increasingly concerned about the safety and security of Chinese savings. Chinese resentment at the destruction of the value of its savings is increasing.

In an opinion piece published on 7 June 2012 in Financial Times, Jin Liwung, Chairman of the supervisory board at the China Investment Corporation, the nation’s sovereign wealth fund, writing withKey Jin, assistant professor at the London School of Economics, responded to criticism of China’s response to the European debt crisis as follows:  “From the outset of the crisis China has responded positively and firmly to Europe’s appeal for support. But it should be received as an important and responsible stakeholder, not as an outside creditor relegated to lower levels of seniority in moments of urgency. It should be treated equally with the European Central Bank in the event of any debt restructuring.

Reducing international engagement would allow China to write down its investment over time. This would also minimise the need for further investment to protect the value of existing holdings, freeing up resources for internal requirements.

As in any divorce, both partners – China and its major trading partners- increasingly recognise the lack of mutual benefit in continuing existing arrangements.

At the July 2012 G-20 meeting in Mexico, China made it clear that it would not initiate the type and scale of bank lending blitz that it did after the initial phase of the crisis to boost Chinese and global growth. With China unwilling to take steps to become the consumer of last resort or open its markets to foreign businesses, developed countries are increasing critical of Chinese policies.

China sees diminishing gains for engagement with external parties other than on its own terms. It resents external pressures on its economic policies, currency value, trading practices, political system, foreign policy and human rights record. China resents the hypocrisy of developed nations in dealing with a great power.

Chinese history is shaped by successive humiliations in dealings with the West. Economic disengagement is dictated, in part, by developing breakdowns in the relationship between China and its trading partners.

China’s has shifted its priority to food and energy security to sustain its development. China is purchasing food and energy independence, through targeted investment in foreign suppliers. In some cases, these investments also secure external markets for Chinese goods and services.

For China, a reversal of a policy represents a return to traditional economic self-reliance and a limited interest in trade. As Robert Hart, 19th Century British trade commissioner for China, wrote: “[The] Chinese have the best food in the world, rice; the best drink, tea; and the best clothing, cotton, silk, fur. Possessing these staples and their innumerable native adjuncts, they do not need to buy a penny’s worth elsewhere”. Engagement with gweilos (a Cantonese term meaning foreigners or foreign devils) is the exception not the norm in Chinese history.

Fringe Dwellers

For nations without a large domestic economic, adequate economic resources or need for export markets retreat from global integration poses challenges.

For example, smaller nations cannot influence exchange rates to the same exchange as the major powers. Instead, countries require pragmatic strategies to prosper.

Alternative trading blocs to counter the shift to closed economies may evolve.

Natural resource rich countries may ally themselves with major nations, such as the US, Europe or China, becoming preferred suppliers of food, energy or raw materials. In turn, they can reciprocate by becoming markets for products or services and investment of their trading partners.

African countries are pursuing this policy, concluding long term supply agreements for agricultural or mineral products sought by China. In return, China is expanding investment, trade and development aid preferentially with these nations, co-ordinating transactions by Chinese businesses and banks.

Australia has emerged as an important source of raw materials for China. Russia has become an energy and commodity supplier to Europe. Within the framework of NAFTA, Canada has become an important energy supplier to the US while Mexico provides low cost labour to American businesses.

Strategically located, smaller trading oriented nations like Switzerland or Singapore can become important trading or financial centres, providing trading, logistics, financial or investment services.

If they could overcome historical animosities and territorial conflicts, then Japan and China could evolve a mutually beneficial strategic partnership. Japan is China’s second largest trading partner. Japan is also one of its largest foreign investors.

Japan possesses advanced technology and needs markets for its exports. China is a large potential market and Chinese businesses would benefit from Japanese skills and intellectual property. Still the world’s largest pool of savings, Japan is continually seeking investment opportunities.

Despite a history of intermittent political differences, India may seek closer ties with China. Such an alliance would help India overcome constraints including financing large current account and budget deficits, investment capital requirements and infrastructure shortages. China would improve access to raw materials and India’s large domestic market. Chindia is not far-fetched given the two countries have rich cultural links reaching back to ancient times and increasing trade links.

Nations will have to abandon historical ties and biases, trading off political status against economic prosperity and security in the new world order. In the British TV series Downtown Abbey, Cora Crawley asks her mother-in-law: “Are we friends, then?” The Dowager Countess’ reply is instructive: “We are allies, my dear, which can be a good deal more effective.” Smaller nations, unable to retreat into autarky, will need to adjust strategies to make the most of the new world order.

Redrawing Battle Lines

The global financial crisis represents a historical discontinuity, driving significant changes in economic and financial systems as well broader political structures.

Policy makers want to believe that the problems will be resolved and the world will revert to the status quo. The depth of the problems and absence of easy cures means that major changes are likely. A confluence of economic self-interest and necessity may drive a reversal of global integration, favouring closed economies with more narrowly based strategic linkages between nations. This shift has important implications.

Greater integration, free trade and free capital movements promoted growth. Now, lower economic growth is reversing the trend, removing a key driver of growth. Lower growth in turn entrenches the problems of unsustainable debt levels leading to a prolonged period of stagnation further reinforcing a shift to autarky.

A world of closed economies alters the nature of trading arrangements, favouring bilateral agreements or small trading blocs rather than global trade deals. The roles of international institutions such as the World Bank, IMF, WTO and development institutions will need to change if they are to remain relevant.

Political alliances will be reshaped to reflect altered economic relationships. Security arrangements will need to reflect new concerns, including guaranteeing the security of supply and transport of food, energy and essential commodities.

The risk of armed conflict over resources has increased. Recent disputes over potential energy sources in the South China and Yellow Seas highlight this risk. Disputes over water supplies in Asia have also emerged.

The rise of autarky and corresponding nationalism is a dangerous cocktail. Stewart Patrick from the US Council of Foreign Relations recently likened conditions in East Asia to Europe just before the First World War. In the lead-up to the First Word War, Sir Norman Angel famously argued that the complex trade and investment relationships between great European powers made armed conflict unthinkable.

But the possibility of a historical shift does not inform the current thinking of governments, central bankers, financial institutions and businesses. The denial reflects what George Orwell identified as a “major mental disease” afflicting intellectuals: “the instinct to bow down before the conqueror of the moment, to accept the existing trend as irreversible”. A retreat to autarky and pursuance of policies that favour closed economies is now a serious possibility with far reaching consequences that need to be considered.

© 2013 Satyajit Das

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money.