Another Empire Bites the Dust

Posted October 3, 2008

Wall Street’s crack-up presages a global tectonic shift: the beginning of the decline of American power. Great empires and great civilizations have a way of cresting that is pretty well set in historical stone. First, the ideology corrupts. Then the economic model does. Then the currency goes. Finally, military power loses its supremacy.

The United States of America, the “great and good” empire, shows many of the symptoms of cresting, and unfortunately the pace of history has accelerated. Rome’s decline from its zenith took over 300 years; America’s will be timed in decades. After the cataclysm that we have seen in financial markets, economics will accelerate the process. Nero was fortunate that Rome had no Bloomberg. Had it, the city might have burned in a day!

The primary reason for the U.S.’s decline mirrors that of other empires at their tipping point into dotage. Unsustainable living standards at the empire’s core, which are enjoyed but not earned, depend upon flows of wealth from the periphery. In the American case, the credit bubble and its collapse are the flip side of a culture of excess consumption, of which the unwinding will be highly destructive of both U.S. economic and military power and intellectual leadership in the world. That “gain without pain” mentality had become generic in a thriftless, credit-addicted society, where the gap between what people wanted and earned was constantly filled by debt. In the end, the level of debt became so unsustainable that it collapsed of its own accord. The upshot may look like a credit crisis, but in reality it is a moral one.

Current attempts by the Bush administration to stem the rot but avoid inflicting pain on consumer-debtors and on bank-lenders, are not only in vain but hasten the empire’s decline. Such initiatives damage U.S. credibility among foreign creditors who will be asked to finance increasing federal deficits incurred by successive bank bailouts.

Many foreign investors in Asian emerging markets do not fail to remark that when the 1997 credit crisis hit their region, the U.S. mantra was for them to bear the economic pain and restructure the banking sector along strict liberal market lines. Yet when the same crisis hits the U.S., the policy is to print money and socialize credit and risk. Hypocrisy does not command respect. The U.S. dollar will ultimately pay the price as foreign investors start to shun U.S. government debt. The sun never rises on an empire whose currency sets.

By attempting to avoid pain such as write-offs of bad debts against shareholder investments in the financial sector, the administration is depriving the system of the ability to price risk. This is achieved by de facto policies that encourage financial intermediaries to make huge profits in good times by taking on foolish levels of risky investments, which the taxpayer has to pay for when they go wrong.

The “soft option” policies of buying dud loans at par from foolish banks also incentivize bankers to repeat the same mistakes (down the road) that brought capitalism perilously close to the edge of the abyss today. The result will be dysfunctional financial intermediaries that will not be capable of allocating capital efficiently. The economic cost will be high. Most important, it means the U.S. economy is no longer a model for others to follow; the global paradigm has been lost.

Deepening mistrust of the U.S., the loss of key alliances and the rise in terrorist extremism have already increased the economic cost of projecting U.S. power in the world. Global trade liberalization has already given way to inefficient bilateral trade deals between the U.S. and selected countries. The worsening economic prospects for the excess stricken American economy and the likely advent of a Democratic administration increase the probability that “trade selectivity” will soon give way to “trade protectionism.”

Global reform fatigue—particularly in emerging markets—is now widespread. A few years ago, free market economics and supply-side reform (the most successful exports of good empire ideology) were the buzzwords of ultimate economic truth. Now they are contested in places as far flung as Venezuela, Russia, South Africa and China. Increased resistance to these ideas has raised resistance to the empire itself, quite apart from the nefarious economic outfall. The inconsistent and confused response by the U.S. administration to economic crises in emerging markets reflects its own loss of ideological conviction.

It is, of course, not merely the perception of the U.S. that is suffering from the credit crisis. The Anglo-Saxon model of laissez faire economic governance is now being legitimately criticized in rich countries too. In Germany and France, the political leadership is saying, “See, we told you so, the Eurozone model is more stable and welfare-creating than the ‘savage’ capitalism of the Anglo-Saxon world.”

So the Eurozone’s economic architecture will enjoy a renaissance. Governments in OECD countries will become bigger and more interventionist. The rich and the corporations will be taxed more to pay for this. With climate change and food security as mantras, state intervention will receive popular support. The cost will be falling government bond issuance, higher bond yields and inflation.

The rise of the Eurozone economic model will be underpinned by developments in the world post-credit crisis. For years to come, financial institutions will be forced to deleverage. That means a contraction in global credit, followed by much moderate growth, no more than in line with nominal GDP growth.

During the last 20 or so years of global disinflation, leverage was encouraged to replace thrift for the OECD consumer. Now that will be reversed, and this will be a long learning process for many economies. The consumer will discover “value shopping.” Low leveraged economies such as Germany and Japan will be winners in this environment, while the overgeared Anglo-Saxon economies will be the losers. In these economies, exporters or import substituters will gain, along with those that sell consumer staples and basic services. Luxury goods and services providers will be the losers.

The unwinding of credit excesses in Anglo-Saxon economies will impact Asia too. The credit bubble was the mirror and means of financing global excesses ranging from Chinese real-estate bubbles to the excesses of the U.S. consumer, which, in turn, caused the current-account deficit. As global credit shrinks so will the excesses and imbalances which it financed.

In the environment of the post credit crunch, lowly leveraged economies will benefit over over-geared ones. Asia, of course, has low leverage. Even so, Asia’s postcrisis economic model will be under threat too. That’s because the model is based on manufacturing products for consumption in the overgeared and undersaving West. That looks less sustainable when those consumers are being forced to rediscover thrift. Contracting liquidity will cause recession in the U.S. and the EU. So exports to Asia will slow and manufacturers’ margins will be squeezed.

In the long run, Asia needs to move to a domestic consumption driver. In the ensuing cyclical recovery in the global economy, Asia will have to rebuild capacity in domestically oriented industries and services. For emerging economies such as China, which have overinvested in output of tradable goods for export, declining foreign demand is likely to leave swathes of factories empty. This will be difficult to compensate for by boosting domestic demand. Domestic consumption is just too small a portion of GDP (36% in China). Even extra infrastructure investment of 1% to 2% of GDP would be dwarfed by investment in factories to produce for export (in excess of 20% of GDP by my estimate).

These developments might matter less if symptoms of U.S. military weakness were not starting to manifest themselves too. The recent Russian invasion of Georgia was undoubtedly partly based on the judgment that U.S. military capability was completely tied up in Iraq and Afghanistan, limiting its ability to act elsewhere.

There is no question that the Russian behavior is at least partly linked to the perceived decline of the U.S. America’s troubles in the Middle East, coupled with the economic downturn, have emboldened the Russians to claim that the days when the U.S. was the only superpower are now over; the future belongs to “multipolarity,” as the Russians and the Chinese say.

This has to be put in context however. In purely military terms, the U.S. is still about a decade ahead in technology and quantity of weapons in comparison to any other nation on Earth. True, going forward, the U.S. may not be able to spend as much on defense as it has done in the past, but the decline in defense expenditure, even if it comes about, will be slow and drawn-out.

I cannot see any other power trouncing the U.S. in military terms until well into 2030. The Chinese are not trying—they are developing “killer technologies,” which are designed to checkmate the U.S., rather than meet it quantity-for-quantity.

The Russians may try, but will never succeed in catching up with the U.S. Even using energy as an economic weapon against the EU is a double-edged sword, because the Russian economy and Moscow’s budget depend on energy exports. And for the next decade they cannot be sold elsewhere; increased supplies to China would depend on a decrepit rail system.

But neither does Moscow see a direct link between military and economic strength, pointing out that China’s GDP is 10% of the U.S., while Russia’s is 25% (with vastly superior military technology) and no one messes with China. The view is that in the days of the Cold War, when Russia’s economy was also a fraction of the U.S., and neither the U.S. nor Russia could use nuclear weapons, Russia bargained as an equal.

After two decades of relative calm, Central Asia is about to become a major battleground of competition between Russia and China. For a number of years, the U.S. dreamed about exploiting Central Asia’s energy resources for Western purposes; local governments were courted, and a few American military bases were established in the region. But the tactic failed: Frightened by Washington’s incessant preaching of human rights, the region’s autocratic governments turned again to Moscow for protection. And the Russians—now bolstered by their military victory in Georgia—have every reason to press their advantage into Central Asia.

Meanwhile, the Chinese are following suit. Two key energy projects—an oil pipeline to Kazakhstan’s sector of the Caspian sea that will deliver two million barrels per day into western China, and a second project linking Turkmenistan’s gas to Chinese customers—will reach fruition in two years. The Chinese, more dependent than ever on energy imports, but still without a navy that can protect its lengthy maritime supply routes, have no option but to turn inward to Central Asia. In the longer term, Russian and Chinese interests do not coincide. Since Russian oil production is already falling, Moscow needs Central Asia’s resources in order to make up any shortfalls. So the Russians will look askance at Chinese incursions into the region.

But at least for the moment, the Russians and the Chinese agree on one point: They are boosting the importance of the Shanghai Cooperation Organization. Transforming this hitherto ineffective body into a military alliance has one purpose: to keep the West in general, and the U.S. in particular, out of the region. So Central Asia will be parceled out between China and Russia, with Western governments reduced to a role of spectators.

The so-called “Washington Consensus,” which was implemented after communism’s collapse in the early 1990s, is now fading away. Countries will pursue various other models that involve no democracy, no separation between the state and its economy, heavy protectionism and state intervention in economic activities, etc. The crumbling of the U.S. economic model does not mean that a new consensus will emerge based on the Chinese model of development, or the Russian one. They are unlikely to be the new attractive models for the world. So we are seeing the renationalization of economic models, with countries pursuing different approaches.

These developments increase risk for investors in emerging markets very substantially in a number of ways. First, economic models will no longer converge with liberal market ideals, meaning that both growth and returns will be more uncertain. Second, the sacrosanct nature of foreign investment, already contested in Russia, will deteriorate further, and consequently property rights and titles will be weakened. Third, increasing economic nationalism will make the operating environment for private corporations, particularly foreign-owned ones, more difficult and less conducive to earning profits, particularly in sectors where local insiders are permitted to earn unjustified economic rents.

David Roche is president of Independent Strategy, a London-based consultancy.