The System Worked_How the World Stopped Another Great Depression

by Daniel W. Drezner

  China has become the hegemonic actor in one arena: official currency reserves. China has accumulated the world’s hard currency reserves, swelling from close to $2 trillion in 2008 to more than $3.4 trillion five years later,68 a figure that dwarfs the reserve assets of any other actor, including both the United States and the European Central Bank. As of June 2013, the United States possessed roughly $145 billion in official reserves, while the European Central Bank possessed less than $75 billion.69 Indeed, Japan, Russia, India, and Brazil each possess reserves that are several multiples of those of the United States and the eurozone.

  China has undeniably leveraged these reserves to increase its power vis-à-vis smaller countries70 and to exercise economic statecraft in some new and influential ways. China ratcheted up its foreign aid through its own state-run banks. The Financial Times reported that between mid-2008 and mid-2010, Chinese loans to developing countries and companies exceeded those of the World Bank.71 Bloomberg reported that in 2010, Chinese lending to Latin America exceeded that of the World Bank, Inter-American Development Bank, and US Export-Import Bank combined.72

  That said, China’s ability to translate its economic clout to political influence has been limited to its interactions with smaller states. China’s fitful efforts to use its reserves to economically pressure the United States have yielded few, if any, concessions.73 Indeed, despite considerable hype among pundits, in 2012 the Defense Department concluded that “attempting to use US Treasury securities as a coercive tool would have limited effect and likely would do more harm to China than to the United States. … The threat is not credible and the effect would be limited even if carried out.”74 Similarly, China has not demanded any quid pro quo for assisting the eurozone economies.

  The data for each of the foregoing measures are flawed. As with intra-European trade and investment, the existence of Hong Kong distorts some of the figures for China’s influence. The rise of offshore financial centers can skew the data on capital and investment flows as well.75 Brazil’s, India’s, and Russia’s output data might undercount gray market activities. Chinese data have long been suspect because of the political incentive for provincial leaders to inflate output figures at key moments.76 Still, the picture these aggregate figures paint is clear enough. The United States and the European Union still command significant amounts of market power. On most dimensions, China is almost as significant an actor. Based on the trend lines, it is not surprising that observers expect it to be more powerful in the future. Japan is no longer in the first tier of great powers, and Russia, Brazil, and India are not close to ascending to that first tier as well. Only on the dimension of currency reserves does the distribution of power resemble the perceptions discussed in the previous section. Therefore, the primary focus of the rest of this chapter is on the capabilities of the United States, the European Union, and China.

  How have markets rewarded the policies of the United States, the European Union, and China? At first glance, the financial crisis would seem to have clarified the hard limits of US power. The ability of the US government to sway market actors appeared to be on the wane. Ratings agencies, for example, put the United States on notice that there were limits to its attractiveness. Standard & Poor’s downgraded the US credit rating after the debt-ceiling negotiations in the summer of 2011; Egan-Jones downgraded US government debt on numerous occasions after 2008.77 The World Economic Forum downgraded the competitiveness ranking of the United States because of its mounting fiscal problems, as did the Legatum Prosperity Index. US businessmen became extremely gloomy. In a 2011 survey, only 9 percent of Harvard Business School alumni thought the United States would outperform the other advanced industrialized states; 21 percent thought the US would be an economic laggard. Two-thirds of respondents expected America to lose ground to Brazil, India, and China.78 Economics commentators debated the Federal Reserve’s waning ability to move markets in the desired direction. Both the second and third rounds of quantitative easing had underwhelming effects on aggregate economic growth.

  It is worth distinguishing between the actions of ratings agencies, however, and the actions of markets. On the latter front, the influence of the US government and the attractiveness of the United States economy remained unbowed. Despite the actions taken by S&P’s and others, for example, market actors did not punish the US economy. As Bloomberg reported a year after the S&P downgrade: “mortgage rates have dropped to record lows, the government’s borrowing costs have eased, the dollar and the benchmark S&P’s stock index are up, and global investors’ enthusiasm for Treasury debt has strengthened.”79 As figure 5.14 shows, benchmark borrowing rates continued to decline for the United States until June 2013, after the Federal Reserve indicated an eventual tapering of quantitative easing in its forward guidance. These responses contradict the claim that markets did not respond favorably to US policy measures.80

  In terms of economic fundamentals, the United States has weathered the Great Recession better than other developed economies. US job creation and GDP growth outpaced most of the other advanced industrialized economies. At the same time, the United States has gone further than other OECD economies in deleveraging its consumer and business sectors.81 This success in deleveraging carried over into the public sector as well. The federal budget deficit as a percentage of GDP declined from over 10 percent in 2009 to 4 percent in 2013. It was the fastest-paced decline in US postwar economic history—including the military drawdowns following the Vietnam War and the end of the Cold War.82 Eventually, the observers caught up: Standard & Poor’s upgraded its outlook on US debt in June 2013.83 The same month, A. T. Kearney ranked the United States as the most attractive place for FDI—the first time the United States had been ranked first in that index since 2001.84 In all, the market’s responses to the United States suggest that America remains attractive to both financial and human capital.

  FIGURE 5.14 Ten-year Government Bond Yields, 2007–2013

  Source:Trading Economics, http://www.tradingeconomics.com

  But when we examine the market dimension, the European Union runs into difficulties as a great power. Prior to the crisis, many scholars posited that the European Union was an emergent hegemonic power, even raising the possibility that the euro would join the dollar as an international reserve currency.85 The sovereign debt crisis scuttled such talk, however.86 Since the start of the Great Recession, the use of the euro as a means to store value and as a medium of exchange has either stalled or declined. Use of the euro remains well below that of the dollar.87 Since the start of the sovereign debt crisis, the ratings agencies have repeatedly downgraded the bond ratings for most of the European economies. And national governments, as well as myriad European Union bureaucracies, face far stronger constraints from both markets and voters. The sovereign debt crisis in Greece caused financial markets to apply pressure on other eurozone economies that looked vulnerable. The spreads between the sovereign borrowing rates of the Southern Mediterranean countries, such as Italy, widened in comparison to Northern European countries, such as Germany.88 The result has been years of lackluster growth and in which no steps have been taken toward public-sector or private-sector deleveraging. The austerity measures proved to be deeply unpopular with wide swaths of the voting public. Indeed, as time passed, most of the European Union economies found themselves stuck between two diametrically opposed structural forces. On the one hand, capital markets demanded more credible fiscal policies and promises of backstopping from the European Central Bank. On the other hand, irate publics opposed cuts to social services—sometimes violently. For the first time in decades, European officials found themselves on the receiving end of IMF criticism.

  Markets have not constrained all elements of the European Union equally. As figure 5.14 shows, German borrowing rates remained low during most of the sovereign debt crisis. Furthermore, after European Central Bank president Mario Draghi announced in September 2012 that the bank would fully backstop sovereign debt in the eurozone economies, the
market panic began to ease and borrowing rates started to drop in the distressed parts of the eurozone (such as Italy). Still, financial pressures have forced significant changes in the continental version of the coordinated market economy, including imposing austerity on the macroeconomic side and forcing the liberalization of labor and product markets on the microeconomic side. Even countries that are not in the eurozone—such as Great Britain—felt compelled to take similar actions. Markets imposed tight constraints on the European economy.

  If market actors imposed hard constraints on the eurozone, the opposite seemed to be the case for China. Yet, there were still some warning signs. The World Economic Forum ranked China’s competitiveness between twenty-sixth and twenty-ninth in the world for a five-year period after the 2008 financial crisis. While this was well above the rankings of the other BRIC economies, China still was well below the United States and ten of the eurozone economies.89 High-profile investors made very public bets against continued Chinese growth.90 In 2013, Fitch downgraded China’s sovereign debt rating because of concerns about its shadow banking system, excessive credit expansion, and the mounting unsecured debts of local governments.91 China’s low ranking in the 2013 World Bank’s Ease of Doing Business Index—ninety-first—highlighted gaps in the rule of law between Beijing and the OECD economies.92

  As with the United States, however, China’s market performance belied the assessments of ratings agencies and ranking exercises. China’s primary problem both before and after the Great Recession was trying to contain massive inflows of foreign capital because of its dynamic and growing market. A. T. Kearney had ranked China as the most attractive locale for FDI for the five years prior to 2013.93 Multiple private-sector assessments predicted increasing flows from the developed world to emerging markets in general and to China in particular.94 China’s fiscal and trade surpluses meant that its international borrowing needs were close to nil, and that it could access capital with a minimum of fuss. Many of the OECD economies’ sovereign debt ratings fell further and faster than China’s.

  Measuring state capacity is a murkier project; few objective metrics are available. Yet, one can still argue that in this arena, the United States possesses significant network and structural advantages over both the European Union and China. The advantage the United States has over the European Union on this dimension is its degree of centralization. No one doubts the existence of the United States as a coherent actor in the global political economy. Matters are less clear with the European Union. The division of authority between the European Commission, European Council, European Central Bank, and national governments in dealing with the outside world varies widely across issue areas. When the European Union can act as one, its capacity is formidable. When it is politically or legally divided, that collective strength begins to dissipate—and, as we shall see in chapter 6, the European Union was deeply divided on important policy dimensions. In contrast, the United States federal government can be discussed as a more coherent actor. It also possesses more network centrality across a range of governance structures.95 At a minimum, the European Union’s internal divisions have stripped away the agenda-setting power it had begun to demonstrate in the pre-crisis years.

  The United States also possesses much greater state capacity than China in dealing with matters of global governance. As Amitav Acharya puts it, “While China has increased its participation in multilateralism and global governance, it has not offered leadership.”96 Indeed, on numerous metrics, China’s engagement with global governance structures is even less than that of the other BRIC economies.97 One scholarly assessment observed that “China’s political elites and bureaucracies [were] ill-prepared for the country’s sudden high-profile in global affairs.”98 Part of this is due to legacy effects; China only joined most global governance structures beginning in the early seventies, whereas the United States founded or co-founded most of the salient international organizations.99 Furthermore, the Chinese policymaking apparatus suffers from other flaws. One recent assessment compared China to other East Asian development states and concluded, “Intense rivalries among Chinese state agencies and local governments put considerable implementation constraints on indicative planning and market-conforming state interventions.”100 Corruption also remains an intractable issue within the Chinese state.101 These disadvantages may ebb over time as China modernizes. Still, during the period under question, China’s state capacities were more constrained than those of the United States.

  Tables 5.1 and 5.2 summarize the results of the power audit. Clearly, for global economic governance, the great powers are the United States, the European Union, and China—the other BRIC economies, as well as Japan, can be considered first tier on only a few dimensions. While the hegemonic coalition of great powers has expanded, it has not expanded by as much as BRIC enthusiasts predicted. Just as clearly, table 5.2 reveals that the United States retains primacy in the global economy. The United States possesses great-power status across the most dimensions. Even if its relative share of state power is not the same as it was at the turn of the century, the United States has demonstrated full-spectrum resiliency in the wake of the 2008 financial crisis. If the European Union functioned as seamlessly as a single actor, then on many dimensions its power would exceed that of the United States. As it stands, however, the weakened capacity and integrity of the eurozone have sapped its convening power. Only in a few areas, such as trade and regulatory matters, does the European Union function as a great power equal to the United States. Finally, China is indeed rising. It possesses capabilities that it did not possess even a decade ago across several dimensions. That said—and contrary to public perceptions—it is still the weakest of the great powers.

  Stepping back to take a broader view, we find that both public and elite perceptions about the distribution of power are at variance with the reality. To be fair, these perceptions contain an important kernel of truth. China’s power is rising, as are the BRIC economies generally. Across numerous dimensions, the power of the advanced industrialized democracies has declined. Nevertheless, most commentators miss three salient facts. First, China is vastly more powerful than the other BRIC economies. Brazil, India, and Russia are important middle-rank economies that belong in groupings like the G20—but they are not catching up with the United States or the European Union on most dimensions. Second, while China has become a great power, it is still demonstrably weaker than the United States and the European Union on multiple dimensions. Ironically, the Chinese seem perfectly aware of this—it is Western analysts who make this error. Finally, on some significant structural dimensions—currency use, asset ownership, military power, and network centrality—the United States remains the uncontested hegemon.

  TABLE 5.1 Great-Powers Assessment

  TABLE 5.2 Great-Power Rankings

  How Have the Great Powers Made Global Governance Work?

  Based on the audit just conducted, one can find reasons commentators would be dubious about the ability of powerful actors to manage the global economic order. First, the Great Recession weakened the post–Cold War hegemonic coalition, and weakened it badly. The United States suffered a modest relative decline; traditional allies, such as the European Union and Japan, were hit hard by the crisis. Japan fell from the ranks of first-tier great powers. In some arenas, such as trade or anti-piracy operations, the pre-crisis hegemonic coalition was insufficient to guarantee robust global governance. In other arenas, such as reforming the international financial institutions, the European Union countries resisted reforms because the proposed changes weakened their influence. China, a country that looks very different from the United States or Europe, is now a first-tier great power. With this new managing coalition, making the system work is simply more difficult.102

  Another reason for pessimism is the mismatch between perception and reality. The previous section showed the gap between the United States, the European Union, China, and everyone else. Other commentators include the other BRIC
countries, as well as the other actors in the great-power club.103 So do many global governance structures, as noted in chapter 2. The debate about which actors belong in the hegemonic coalition raises an important point: the uncertainty about which countries belong must be factored into any analysis of the future of global economic governance. A lack of consensus in this regard allows misperceptions to fester. If enough actors believe that the distribution of power has shifted in a particular direction, then those perceptions can socially construct that reality for a limited period of time. If India is granted the perquisites of economic great-power status, for example, it will also be expected to assume the responsibilities that go along with that status. Collective perceptions can force countries to either shirk or take on ill-suited obligations—particularly if the perceptions deviate significantly from the material facts of life. This explains some commentators’ frustration with the failure of the BRIC economies to shoulder the burden of leadership in global governance structures.104

  Still, the system worked as well as it did for a few very simple reasons. The United States continued to exercise leadership across a wide variety of issue areas, while the European Union acted as a traditional supporter on questions of maintaining economic openness. China acted more like a supporter and less like a spoiler of the system. When they were in agreement, the collective capability of these three economies was sufficient to ensure that their preferred governance solutions won out.105 When they disagreed, the status quo bias was in favor of policies that promoted openness.