Systemic risk and the financial crisis

Kirshner argues that, among the flaws in the US-dominated model of international financial order revealed by the 2008 financial crisis, was a disregard for systemic risk (117). Systemic (sometimes referred to as endogenous) risk — what it is, how to mitigate it, to what extent financial globalization has made it inevitable, the relationship between systemic risk, statistical modeling, and crisis — has come to occupy a central position in discussions about post-crisis financial regulation. I recently came across this video, describing systemic risk, from the London School of Economic’s Systemic Risk Centre. I thought I’d post it here, in case you’re interested.

For further reading, this page provides a helpful introduction to some of the sources and amplification mechanisms of systemic risk, as well as some of the policy solutions aimed at addressing this phenomenon.

China’s Economic Rise

[posted on behalf of seongminahn2017]

Both Kirshner and Beckley discuss prospects of U.S.’s future power with Kirshner supporting the declinist theory and Beckley supporting the alternative theory of U.S.’s durable power. However, their arguments are not direct opposites, since Kirshner focuses more on the future role of the dollar as the main currency and the future monetary system. We see that Kirshner analyzes both the situations in the U.S. and China to make predictions on how the relation between the two countries and their structural position within the international system affects their relative powers. Meanwhile, Beckley heavily focuses on the U.S., and talks more on his thoughts of how globalization and hegemonic responsibilities will influence U.S.’s power.

Jonathan Kirshner, American Power after the Financial Crisis

Kirshner, along with the World Bank, predicts a shift from the current monopolistic dollar monetary system to a multiple currency system in the future. He claims that China’s RMB will become the main currency in East Asia; he stresses that the US dollar will not be supplanted, but that U.S.’s relative power will decline. His rather frequent emphasis on the U.S.’s relative decline in power and China’s relative increase in power strengthened his argument especially because he acknowledged the obstacles, such as the fragile domestic financial sector and the Communist Party’s ideological dependence on economic growth, that China will face on its mission to internationalize RMB.  The inclusion of U.S.’s and China’s challenges brought forth a more informative outlook on the future roles of the two countries’ currencies and power.

To summarize, China wishes to promote RMB as an international currency for monetary policy autonomy and increased international political influence often in the form of structural power. The global financial crisis, which harmed the credibility of US dollars and exposed the Chinese elites to the dangers of relying too heavily on dollars, partially helped China to advance in its wishes through bilateral agreements with Asian, Latin American and Middle Eastern countries. These bilateral agreements, though only the first step to RMB internationalization, brought remarkable changes, with more than 9% (1% in 2010) of China’s total trade settled in yuan in 2011 according to Kirshner. Even though these numbers cannot validate claims about the complete RMB internationalization, they do shed light on the relative increase in China’s power. I also think that this statistic is important in that it debunks the argument that China will not be able to internationalize the yuan until it fully liberalizes its economy into one free of capital controls.

Then, analyzing the future of the dollar’s international role, Kirshner indicates that regional currency blocs and general preference for diversification of currencies from the global community will challenge the USD. After the global financial crisis, the Chinese elites demanded the need for insulation and became conscious of relying too much on the USD, and consequently decided to diversify their investments. The influence of the Chinese elites relates to our previous IPE readings that highlighted the influential power of ideas and perceptions; investor’s previous belief in USD gave the U.S. the benefit of the doubt during financial crises, but the investors are becoming more skeptical.

In conclusion, he predicts that assuming the relative dollar diminution, the U.S. will experience reductions in power through the loss of benefits (seignorage, balance-of-payments flexibility, structural power, monetary autonomy), challenge of new burdens (as loss of faith in the dollar leads to closer scrutiny of the U.S.’s economic decisions) and emergence of vulnerabilities (to economic coercion from other states).

Michael Beckley, “China’s Century? Why America’s Edge Will Endure”

Beckley addresses two theories: the declinist theory and the alternative theory. The declinist theory states that U.S. is in decline relative to China due to globalization and hegemonic burdens, while the alternative theory states that U.S. will remain powerful due to globalization and hegemonic burdens. After criticizing the declinist theory, he supports the alternative theory.

Referring to the polarization effect, Beckley states that globalization will lead to the concentration of wealth and power in those states that are already wealthy and powerful because U.S. has competitive advantages in economic, technological and military power. In respect to U.S.’s economic and technological advantage, he mentions global chains in order to show that despite the increase in outsourcing, China and other countries will not learn the technological and innovative skills, as the diffusive effect and the obsolescing bargain theorizes, because global chains give U.S. the competitive advantage of participating in the high-valued levels of production such as the innovation process. The developing countries, according to Beckley, are stuck in the labor aspect of production.

The Beckley reading was helpful in that it did not solely focus on monetary aspects like the Kirshner reading had, and instead mentioned aspects of security, finance and trade when discussing the declinist view’s hegemon dilemma that weakened the U.S. in relation to China.

However, Beckly’s critique of the declinist view, saying that this view only looks at the overbearing responsibilities of the U.S. as the monetary system-maker, seemed weak. He argues that U.S. will remain powerful because its role allows the U.S. to be a privilege-taker as well as a system-maker. This argument is weak, especially since privileges, like the privilege of running a large balance-of-payment deficit, are directly affected by the faith in USD, which Kirshner shows is definitely weakening in response to the global financial crisis and U.S.’s tendencies to dump the burden of its crises to other countries. With a great decrease of faith in US dollars, moderate levels of wielding US structural power will not be enough to keep the US dollars’ role in the international system from declining.

Is China’s Rise A Threat to America?

China’s stunning economic growth would have to cause political implications, which triggers heated discussions in the U.S. about whether America’s hegemonic status in world politics is coming to an end. In this week’s readings, Jonathan Kirshner and Michael Beckley examine the effects of China’s rise on the power of the United States, and draw two opposite conclusions. Specifically, Kirshner assets that the global financial crisis of 2007-2008 altered the international balance of power, resulting to the relative erosion of power of the U.S. and the enhanced influence of China. In contrast to the position of US declinists, Beckley argues instead that despite the expanded hegemonic burdens, the United States has in fact raised its strength in wealth, innovation, and military power vis-à-vis China over the last two decades. Even though neither argument is all-sided, overall I tend to agree with Beckley, that U.S. dominance in world politics will endure for years to come.

In the article “China’s Century?”, Beckley focuses on three categories of empirical evidence to measure national power: wealth, innovation, and conventional military capabilities (Beckley, 56). When measuring wealth, Beckley reminds his readers that what matters for national power is “surplus wealth” rather than net GDP. Using data from 1991 to 2010 which shows that the U.S. per capita incomes outpaced its Chinese counterparts, Beckley concludes that the U.S. is even wealthier compared to China than it was in 1991 (Beckley, 62). In discussing the ability to innovate, Beckley claims that globalization may not allow developing countries to absorb innovations elsewhere because “the infrastructure necessary to absorb certain technologies cannot be copied from a machine” (Beckley, 54). Rather, the “absorptive capacity” is determined by a state’s intangible assets such as property rights, social networks, capital markets, labor skills etc. (Beckley, 55). As a matter of fact, many Chinese firms engage primarily in outsourcing manufacturing and basic engineering, both of which are not likely to inspire technological innovations. Therefore, Beckley concludes, it is difficult for China to catch up with the U.S. in terms of research and technical development. Finally, regarding to military capabilities, Beckley suggests that “military effectives is determined by a country’s level of economic development, as measured by per capita income’ (Beckley, 75). In other words, China’s defense industries are inferior to those of the U.S. because “they lack the economic capacity to integrate individual technologies into cohesive military systems” (Beckley, 74). To sum up, Beckley’s central argument is that in the short run, China will not be a threat to the US-led world structure.

However, Jonathan Kirshner addresses this issue from another perspective. He defines the 2008 global financial crisis as the “learning moment” in world politics, one that has led to general disenchantment with the US-led economic order as well as the relative erosion of U.S. power. As other countries suffer from buyer’s remorse for emulating the U.S. financial model, Kirshner claims that “there is greater demand throughout the globe for alternative economic systems” (Kirshner, 140). Since international macroeconomic relations are conditioned on world politics, Kirshner argues, accordingly, the crisis not only undermines the legitimacy of America economic ideas, but it reduces the political influence of U.S. as well (Kirshner, 132). To make a contrast, Kirshner highlights China’s swift recovery from the financial crisis, which helps to accelerate the process of RMB internationalization, and enhance China’s structural power in world politics. Regarding the internationalization of the RMB as an irreversible trend, Kirshner analyzes in details the extent to which the domain of the dollar will be encroached. To sum up, Kirshner is pessimistic about the future of the dollar, as he writes, “In the past, US financial and monetary system had served to enhance US power. In the future, however, it may represent burdens, constraints, and even sources of weakness” (Kirshner, 149). Considering dollar as a “suspect currency” whose appeal is likely to be challenged by multiple currencies, notably, the euro and the RMB, Kirshner asserts that new vulnerabilities of the dollar after the financial crisis would have negative effects on the U.S. structural power.

However, Kirshner’s statement that the 2008 financial crisis has altered the international balance of power lacks is devoid of empirical evidence. To start with, the ideological disenchantment with the U.S. financial system that Kirshner predicts does not occur, as the U.S. market remains the most sophisticated and attractive market to foreign investors. In addition, the US government has imposed greater oversight on financial markets to avoid another systematic financial meltdown. Indeed, the main reason for China’s relatively fast recovery from the financial crisis is Chinese government’s central planning over its domestic finance sector. However, as their choice in “impossible trinity” suggests, most countries view open markets as crucial to economic developments, and thus I doubt that China’s capital control policy will look more appealing than before. In short, Kirshner provides no statistical data to show that the 2008 crisis makes government-led growth outstrip the expansion of well-regulated free markets. Moreover, Kirshner’s prediction on dollar diminution remains unfulfilled. To me, the dollar’s currency power continues to foster the structural power of the U.S. since there is no other currency to be established as a true rival. As a matter of fact, the Eurozone debt crisis has yet to be solved, and currently the RMB only counts for 2.17% of global payments.

Overall, I find Beckley’s central claim that “China is rising, but it is not catching up” to be more persuasive due to two reasons (Beckley, 44). First, Beckley clearly defines power in terms of resources, and explains why wealth, innovation, and conventional military capabilities are the three most vital sets of resources in world politics. As a result, the credibility of the three factors in measuring national power is well-established. Second, Beckley uses graphs and statistics to support his analysis, which serves as empirical evidence for his main arguments. However, a weak point of Beckley’s analysis is his inattention to US domestic problems in the analysis. For instance, increased income equality and huge amount of debts might have deepened American’s concerns about losing the edge. Nonetheless, I argue that China’s rise lead to the US’s decline in power, and the US-led international order will maintain for a while.

The Rise of China and the International Order

The arguments stating that the United States is in an irreversible decline and that it is inevitable that China will supplant the U.S. as the global hegemon have the sort of fatalistic allure that the American public loves. China provides a real and tangible threat not present since the fall of the Soviet Union; an existential threat that can drive Americans together just like the Soviets did. However, as Beckley so astutely points out, just because China is rising does not mean that it presents the next threat to American power.

The idea that history repeats itself is certainly not accurate, not two situations can be exactly replicated for a number of reasons; however that does not mean that the past cannot be used to understand the present. Looking back before China began its incredible run of growth; there was another East Asian power that was striking fear into the hearts of Americans, Japan. Books with titles foretelling of the next world war between America and Japan were being published in droves, references to the supremacy of Japanese industry were woven throughout popular culture like the film Back to the Future, and it seemed like the power of the Japanese economy could not be stopped. However, an observer today would notice that the Japanese economy, while powerful, has stagnated, the population is facing a crisis of retirees, and Japan has now been eclipsed in East Asia as the preeminent economic power.

Looking back further, the mighty Soviet Empire was seen as the centrally planned growth miracle, providing untold prosperity and stability to its citizens through its five-year plans. Developing nations the world over flocked to adopt systems similar to that of the Soviet in the hopes of replicating the magic prompted by Gosplan. Just the same as Japan however, the modern observer would not that not only was its economy the ultimate downfall of the Soviet empire, but the very measures that the Politburo was using to measure its growth were wildly inaccurate.

Further arguments to prove the rise of a hegemonic Chinese power are found with the rise of the BRICS and the BRICS Bank, the counter the current economic system. Frieden describes the protests in Seattle when people showed their distaste for the work the World Trade Organization has done with violent protests. Those pessimistic of the future of American power point to the decline of the West dominated international monetary system as the first sign of a Chinese ascent, with Chinese developmental aid and the BRICS bank signifying the early stages of a new world system. This is another flawed argument. The current economic system is predisposed to stability and the status quo, and domestic politics seem to be the only way to truly bring a country or system down.

While history is not repeating itself, Beckley showed that many of the characteristics with the old threats to American power are present in China, both the good and the bad. China is faced with a population with an enormous bubble of aging workers who will be dependent on a much smaller workforce, just like Japan, and as the Chinese economy is dependent on growth rates that are unsustainable. China is similar to the Soviet Union in some ways as well. The Chinese political elite are notorious for playing their politics and economics close to the chest, so why is it assumed that the numbers being released out of China are not skewed to show a Chinese advantage? Beckley showed that the highly educated force of Chinese scientists many are worried about stay abroad after getting their advanced degrees, and those who stay home often are so afraid of getting bad results that they just do work that is derivative of that produced in innovative centers like Germany. The list goes on and on, but even without skewed statistics and measures, Chinese growth and development cannot be sustained at the current rate, and once their economy begins to slow, the entire system will transition towards that of a regional power, not a hegemonic rival.

Omnipotence and Denial: China’s Threat to US Hegemony

The question of whether China poses a threat to America’s semblance of global omnipotence is one that we see regularly in discussions of International Political Economy, as scholars debate whether China has either the capability or the intention to inflict economic or political stress on the United States. In his book War and Change in World Politics, Robert Gilpin’s chapter, “Equilibrium and Decline” explores the dynamics of the international system in which states must co-exist politically and economically with varying levels of influence and power over one another. Gilpin develops a theory as to how societies decide whether or not to attempt an extension of their international power and to establish their own status quo. Given his theory on the importance of a perceived equilibrium in the international system, Michael Beckley’s insistence of the US’s immunity to any of China’s increasing intentions to affect the international system seems somewhat less reliable, particularly in light of Jonathan Kirshner’s belief in China’s abilities to expand the global presence and strength of its currency.

Beckley’s article, “China’s Century”, firmly denounces “declinist” views on United States hegemony that legitimize the threat of China’s rising economic importance in the international system. Many points in his argument harken back to Daniel Drezner’s general dismissal of China’s ability to turn its economic strengths into political influence; theories have been misled by overly attributing Chinese power to GDP—which is not necessarily an indicator of national power, given China’s high levels of foreign direct investment—and by comparing China’s economic data in terms of growth to China’s former economic status, rather than to the international system at large (Beckley, 59). Furthermore, in order to reap the benefits of Globalization and thus to establish its economic and political credibility as a higher power, China must create the proper infrastructure required to be able to “absorb” the technologies and knowledge necessary for further advancement, which it has proven not able to accomplish (Beckley, 54). Beckley asserts that the biggest threat to the US in terms of China’s growing power lies merely in the psychological: fear of China’s growing export expansion could create unnecessary trade conflicts or immigration restrictions on the part of the US, that would, counter-intuitively, harm the crucial preponderance of the free flow of goods between the US and China. Essentially, Beckley concludes that in order to preserve hegemony, the US must continue to believe in the hegemony itself.

However, Beckley’s argument that one should simply have faith in American hegemony displays a fundamental problem in United States policy that Kirshner highlights. The US itself seems to treat itself as a too-big-to-fail institution. As the Executive VP of the Bank of China, Chen Siqing, points out, the US preserves a frightening disregard for systemic risk (Kirshner, 117) toward which China has become increasingly apprehensive. China has grown over reliant on the dollar in international trade, and its resulting inability to yield power in the international system has led to a determination to increase the role of the RMB, particularly in the East Asian region (Kirshner, 112). Unlike Beckley, who almost entirely rejects China’s ability to expand global influence, Kirshner agues that China very much has the ability to tamper with dollar hegemony: although internationalization of the RMB does not receive widespread support domestically (Kirshner, 120), and many believe that China must liberalize its capital controls in order to expand use of the RMB, Kirshner believes that the requirements for China’s potential for political and economic leverage are not quite so rigid. Although, as Drezner argued, China’s reliance on the value of the US dollar prevents it from using its dollar reserves as political leverage vis-à-vis the United States, Kirshner argues that China will be able to garner some kind of leverage nonetheless; while it remains true that China cannot attain the role of global economic hegemon, that is not to say that China remains unable to expand its influence and thus redistribute power throughout the international system. Even if dollar hegemony is not threatened, the diminution of the dollar’s international role will inflict political constraints on the US: “American power has been supplemented and at times facilitated by dollar primacy, which has made it easier to project its power abroad and afforded an assortment of other political perks” (Kirshner, 131). Thus, the international system may very well see a shift in power dynamics as China extends the prevalence of its currency throughout and perhaps beyond East Asia.

Giplin’s assessment of international equilibrium and the threats of disequilibrium allow us to see the ways in which Kirshner’s view on China’s rising power is perhaps more realistic than Beckley’s. Perhaps the United States is reaching the point as international hegemon where protection of its domination has become almost too difficult and too costly, and preservation of the status quo somewhat more precarious: “Once a society reaches the limits of its expansion, it has great difficulty in maintaining its position and arresting its eventual decline” (Glipin, 185). But regardless of whether or not the United States has reached the point of “eventual decline”, China is clearly dissatisfied with the current distribution of power in the system, which inevitably places the world order in a state of disequilibrium. Beckley simply believes that “the best that can be done is to make plans for the future on the basis of long-term trends; and the trends suggest that the US economic, technological, and military lead over China will be an enduring feature of international relations” (Beckley, 77). In other words, Beckley argues that the US is unconquerable and that nothing need be done in anticipation of an increase in China’s international power. In order to take the stance that Kirshner, on the other hand, takes in predicting China’s very feasible expansion of power and influence, one must acknowledge that China’s windows of opportunity are not limited to monetary hegemony or advancement of state infrastructure. Rather, as Giplin’s theory of equilibrium suggests, power in the international system is relative. Whether or not China is more powerful than the US as a result of its expansionary efforts, a mere extension of currency influence is enough to compromise the supposed omnipotence of the United States. Policy-makers must be prepared to respond to the growing sense of international disequilibrium since the American-fueled fiasco of the 2008 financial crisis.

Always be a Poet, Even in Prose

The rise and fall of the world’s powers has always been fascinating to humans. We study the Ancient Romans, the Hapsburgs, the British Empire, and ask, why did such powerful forces fall so far? Both Gilpin and Beckley explore the reason for this rise and fall of international hegemons. Gilpin uses non-provocative writing to support the conventional declinist view, while Beckley favors a unique, anti-declinist stance using an inflammatory prose style.

In his book, Gilpin describes what he calls “the nature of international political change.” He describes a world system like we know it: there are one or a few world powers that, once in power, establish an international system that will work towards their benefit. However, this status quo is in constant flux—vacillating between equilibrium and disequilibrium—because of the constantly changing amount of powerful resources any one nation has control over (namely, the three indicators of power: military power, economic power, and technological power). Once a nation acquires more of any one of these, it has more control over the international system, and can tip the scale to disequilibrium if it believes that the costs of changing the status quo would be outweighed by the benefits. Gilpin assumes that “the economic costs of maintaining the status quo… rise faster than the economic capacity to support the status quo” (11). There is a tendency for the costs of protection and the consumption of public goods to rise in a powerful, affluent state, while productive investment tends to decline, therefore making it difficult to fund the necessities of protection and the consumption of public goods in order to maintain power. Effectively, the costs of maintaining the status quo rise for the current powers and fall for the rising powers, and disequilibrium ensues. An important point Gilpin makes about this is the diffusion of information and technology from the core to the periphery—a fatal tendency for the state in power, because once the periphery acquires the same information as the core, their “advantages of backwardness” (the fact that non-developed states can latch onto new technologies faster than developed states) will help them industrialize faster and eventually surpass the core in power. Another assumption of the behaviors of states Gilpin makes is that if this disequilibrium is “not resolved, the system will be changed, and a new equilibrium… will be established” (11). He states that a challenged power can do three things to try to keep the status quo: increase its resources, decrease its costs, or lower foreign policy commitments. Gilpin stresses that all of these courses of action are very difficult to do right, and therefore do not work very often. More often than not, disequilibrium leads to a hegemonic war, out of which a new world power is born, and establishes a new international order. Thus, “the process of decline, disequilibrium, and hegemonic struggle will resume once again” (210).

Beckley’s argument focuses on the current issue of whether or not China will surpass the U.S. as a world power. He attempts to debunk the declinist debate in favor of what he calls the “alternative perspective,” which claims that United States power is durable because globalization allows it to exploit its position. While declinists insist that history is bound to repeat itself, Beckley believes that the US and China are currently unprecedented and categorically different from past states. Declinists argue that hegemony is an economic drain on the U.S., since they must provide the public goods of free commerce and liquidity to the world, and that globalization is just as bad, leading to the diffusion of ideas and technology and therefore undercutting American competitiveness. According to Beckley, these arguments are only part of the story; in fact, because of their hegemony, the U.S. is able to reap most of the benefits of the international system, and mold it to their liking. Also, globalization helps the core more than the periphery because wealth and power tend to concentrate in already wealthy and powerful areas, much of what makes the U.S. successful is intangible, and the diffusion of information around the world helps the U.S. because they are primed to absorb and use new information. The second part of the article focuses on the U.S. and China in particular, and why, through analyses of wealth, innovation, and conventional military capabilities, America will not be overthrown anytime soon. For wealth, declinists tend to use only the metric of GDP to support their stance—however, GDP has little to do with the level of economic development and therefore the actual wealth of a nation. Based on per capita income, “the United States is now wealthier compared to China than it was in 1991” (62). For innovation, the declinists’ main argument is how China is turning out an amazing number of scientists and engineers. However, technological superiority and the ability to capitalize on one’s innovations—two things the U.S. has that China does not—is much more important than scientific superiority. For military capabilities, it is ultimately based on economic strength and development—because the U.S. has the capacity to focus a much larger percent of their GDP to maintaining and modernizing their military compared to China, China poses a small threat to the U.S. militarily. In his conclusion, Beckley stresses that the accepted ways of maintaining power—reckless war or retrenchment—are not the most effective ways for the U.S. to keep their position. Instead, he counsels better strategy, and recognizing that the United States’ power will not be usurped anytime soon.

Beckley and Gilpin are clearly on opposing sides of the argument over the rise and fall of international powers. Even though Gilpin does not necessarily say that it is impossible for a hegemon to regain power again and again after bouts of disequilibrium, he makes it clear to his audience that pulling that off would be quite a feat of policymaking, and that it is unlikely. Additionally, at the end of chapter five, he states that, “It is suggested that there exists, at least in modern history, a recurring cycle of war and peace” (204), implying that he believes in the fatality of this order: that no matter what, no world power can last forever. It is therefore safe to assume that Gilpin would fit squarely into Beckley’s “declinist” category, even though Gilpin says nothing on China and the United States (presumably because the book was published in 1981), or even says outright that decline is unavoidable. It is interesting, therefore, that Beckley quotes Gilpin in his article in order to back up his own argument: “As Robert Gilpin and others have shown, ‘[H]egemonic struggles have most frequently been triggered by fears of ultimate decline and the perceived erosion of power’”(78). In context of the book, Gilpin is arguing that this is a precondition to hegemonic struggle—the same hegemonic struggle that is cyclical and inevitable. Therefore, “fears of ultimate decline” are inevitable. Beckley, however, is using the quote to inspire American policymakers to avoid these fears in order to keep the status quo the way it is, and avoid hegemonic struggle with China. Gilpin and Beckley do agree on some points, most notably that retrenchment is unlikely to work. While Gilpin supports retrenchment if executed well, he remains skeptical because it is so difficult to do. Beckley is completely against the notion, and argues that no matter what, U.S. retrenchment would lead to such disasters as “Arms buildups, insecure sea-lanes… closed markets… global warming, water scarcity, and disease” (78).

Robert Gilpin and Michael Beckley differ dramatically in their opinions on the declines of world hegemons. While Gilpin makes his argument more subtly, with more presentation of fact than argument, Beckley starts out his essay debunking declinist theory from the start. It is interesting to point out that, despite Gilpin’s non-inflammatory prose style, his opinions still leak through due to his lack of counterarguments, and, despite Beckley’s call-to-action style, he still quotes Gilpin out of context as if Gilpin supported his ideas.

Earthquakes, dollar hegemony, and the “painful recognition that there is nothing truly solid at the center of our economic lives”

Arnold Genthe’s famous photograph of the destruction of San Francisco after the April 18, 1906 earthquake and the fires it caused.

The New York Times magazine has a great short piece by Adam Davidson of NPR’s Planet Money tracing the origins of confidence in the US dollar to insurance payouts after the 1906 earthquake in San Francisco, J.P. Morgan’s, well, bailout of the U.S. financial system, and the establishment of the U.S. Federal Reserve — the central bank of the United States. Along the way, the article touches on many themes that should be familiar to you from this class:

The front page headline of the May 5, 1906 n Francisco Bulletin reads, “Gold shipped to pay insurance losses. London, May 5. The London steamer St. Paul, which sailed for Southampton for New York, took $1,835,000 in gold, most of which is destined for the agents of British insurance companies to meet San Francisco claims.” Source: http://natedsanders.com/lot-34688.aspx

The adjustment mechanism under the gold standard (which involves literal shipments of gold back and forth across the Atlantic):

At the time, American companies and governments still bought insurance from the old British firms, and the payouts to San Francisco were enormous. As was standard practice, the insurers paid in gold, shipping $65 million worth of bars — an estimated 107 tons, representing 14 percent of all British gold reserves — to the Bay Area. Afraid that all that gold leaving its vaults would permanently impoverish the kingdom, the Bank of England doubled interest rates on British bonds. In response, so many wealthy Americans sent money to England that, a few months after the gold came west from London, $30 million in U.S. gold traveled east. The British vaults were replenished, while the U.S. stock fell by 10 percent in two months.

The headquarters of the U.S. Federal Reserve in Washington, DC

The third face of power (and, as a side note, an excellent illustration of the kind of financial authority I’m studying in my dissertation!):

Few people then — and few people now — could actually describe what it is that the Fed does (in a poll in late 2014, fewer than 24 percent of Americans could pick Janet Yellen as the current head of the Fed from a list of four names, less than would be expected by pure chance). But somehow we have come to accept that the invisible panel of experts, with their confusing statements about interest rates, knows what it is doing.

Global confidence in the U.S. dollar, even after the most recent financial crisis:

Confidence in currencies is measured in various ways — by inflation, by the interest rate governments have to pay to borrow, by the exchange rate with other currencies and so on. For years now, the dollar has performed better than at almost any point in history on all of these measures. Seven years after a U.S. financial crisis nearly brought down the world economy, confidence in the dollar has never been stronger.

The interconnectedness that results from financial globalization and the hegemonic position the United States occupies in the contemporary international monetary system, to the point of dominating other states’ economies:

I spoke with Inan Demir, chief economist of Turkey’s Finansbank. He told me that Janet Yellen has the ability to influence Turkey’s economy more than Turkey’s own central bank or its president. In 2011 and 2012, with its “quantitative easing” program, the Fed created tens of billions of new dollars each month. Enough of those dollars flowed to Turkey that the economy there grew by around 9 percent for two years. “That’s China levels,” Demir pointed out. In 2013, when Ben Bernanke, then the Fed chairman, announced that the Fed would stop making all those new dollars, the Turkish stock market fell by a third and hundreds of thousands of Turks lost their jobs.

And finally, eloquently, the absolutely central role played by beliefs, perceptions, ideas, trust, and irreducible uncertainty in the realm of international political economy:

Before the 2008 crisis, I believed, without thinking too much about it, that there was something solid at the core of our financial system. I imagined the world was governed by math — or, more specifically, by serious men in dark suits who understood the complex formulas playing out in their Bloomberg terminals. I, sadly, wasn’t alone. An embarrassingly strong faith in math and models led so many people around the world to create, buy and underregulate securities that were, in hindsight, built not on mathematical laws but on an ugly combination of fraud and naïveté. For me and many others who watch the markets, the collapse was not just a horrible financial and economic disaster. It was also a psychological and existential blow. It brought on a painful recognition that there is nothing truly solid at the center of our economic lives. There are only the stories we tell one another, the promises we make, the shared views we have about the future.

Source: Kenneth J. Arrow, “I Know a Hawk from a Handsaw,” in Eminent Economists: Their Life Philosophies, ed. Michael Szenberg, Cambridge: Cambridge University Press, 1992.

Commerce and Conflict: Chua, McDonald and Sweeney

This week’s readings explore and challenge the idea of free market democracy as a universal stimulus for development, and the liberalist theory that free trade between nations is more likely to promote conciliatory foreign policies, due to the interdependence of nations. Both Amy Chua and McDonald and Sweeney focus on the role of internal actors and conflict among domestic interest groups in globalization to deconstruct and debunk this simplistic, macro narrative of market liberalization and democracy. Chua examines the phenomenon of market-dominant minorities, where ethnic minorities rise to economic dominance against indigenous majorities, and illustrates that the global spread of free market democracy serves to aggravate destructive ethno-nationalism within a nation, and anti-American sentiment globally. Similarly, McDonald and Sweeney also examine the interplay of globalization and internal political tension, positing that domestic struggle over trade policy directly relates to national decisions of war or peace. Ultimately, as both papers examine the historical context and economic motivations of various domestic interest groups, we can identify the capacity of globalization to redistribute income and political power, and how this impacts conflict within and between nations.

The correlation between democracy and economic growth is often explored in development theories, however consensus on causation is lacking. Chua presents that pursuit of markets and democracy can contribute to the politicization of ethnic difference, potentially even snowballing into civil war: historical cases show that when markets concentrate wealth into the hands of a minority, for instance Chinese in Southeast Asia, this creates an economically successful minority and a politically powerful, but impoverished majority, thereby hardening ethnic resentment. This can result in ethnic outbidding, where political parties play to majority sentiments, bidding against each other to marginalize the resented minority in order to gain votes, as well as in violent, ethnic cleansing movements by the majority seeking to reclaim wealth and national identity (as in the case of Rwanda and Serbia). This evokes the idea that in polyethnic societies impartial institutions are perhaps necessary for stability, since democracy does not equate to constitutional liberalism: Chua uses the Rwandan case to demonstrate how democracy underrepresents minorities and can assist in governments deteriorating into repressive, violent institutions. Moreover, this phenomenon brings up the question of the role of pre-existing structural factors in the success or failure of markets and democracy: the kind of economic and political institutions colonialism leaves behind, for instance, appear to be significant in how free markets and democracy have led to economic inequality, institutional decay, and intra-group conflict; this is apparent for one, in the sharp racial divide institutionalized by Belgian colonists in Rwanda, which resulted in biased economic opportunities for Tutsis, and eventually, genocide.

McDonald and Sweeney consider a different issue, with a related framework: income redistribution due to trade affects domestic political struggles, which impact foreign policy outcomes. They argue in favour of liberal theory that free trade decreases the likelihood of military conflict between states through examining how various interest groups (such as the agrarian class) lobby for commercial policies that then carry key implications for the military decisions effected by the state. As we encountered previously in Stolper-Samuelson theory, society does not benefit uniformly from trade; sectors involved with scarce factors of production will lobby for protectionism in order to gain economic benefits. The authors use a series of regressions to show that high levels of government regulation are correlated with increased risk of military conflict. In the case of Germany and Russia before WWI, they argue that the German government’s strategy to cement domestic support for the Weltpolitik from the industrial and agricultural classes, through offering economic incentives like naval construction and agricultural tariffs, was a factor in deteriorating relations with Russia before WWI. Defense of Russian agricultural interests became paramount, and they replaced their previous restraint in diplomacy with a more aggressive stance – and a higher risk of war.

However, their statement that protectionist firms will “support aggressive foreign policies or war for economic benefits” is not entirely persuasive (380). Territorial expansion and war have enormous social implications beyond potential economic gain, which the authors do not address. Moreover, whereas McDonald and Sweeney present government intervention and the resulting income effects on firms as a key feature in outcomes of war or peace, Copeland proposes that determinants of war may be related to interdependency and expectations of future trade: Germany experienced a decline in expectations of future trade, and coupled with its high dependency on raw materials for industrialization, German pursuit of war can be seen as strategy of survival in a self-help international system. Distinctly, all three readings go beyond the straightforward liberal or realist recipe, exploring the link between income and power to evoke the question of how various political and economic factors evolved and converged to result in conflict: where Chua depicts the socio-political consequences of economic disenfranchisement and inequality among ethnic groups, McDonald and Sweeney, tackle how unequal economic benefits from trade in society affect support for divergent foreign policies, and Copeland explains how differences in relative economic power of states translate into fear of survival, and hence, military action.

Although Copeland and McDonald and Sweeney present opposing views, the former looking at trade volumes (dependency) and the others at trade liberalization (tariffs), taken together their theories present a more holistic picture of the multiplicity of factors driving national decisions and global conflicts. Likewise, although Chua brings up important points about the role of markets and democracy in fomenting ethnocracies, this phenomenon can also be based on linguistic or communal factors rather than simply ethnic. In the case of Sri Lanka for instance, at independence from colonialism, an educated linguistic minority (Tamils) gained disproportionate access to high-paying professions, causing the majority (Sinhalese) nationalists to pursue rhetoric of disadvantage and discrimination. The majority used political influence and legislation to systematically disenfranchise Tamils, eventually leading to violent separatist movements and a pogrom facilitated by the government. In light of Chua’s argument, we can see how income inequality (in many cases resulting from colonialism) combined with sectarian politics and unequal access of minorities to political representation can precipitate lasting and devastating conflict. Essentially, while broad macro theories often present liberal markets and democracy as panaceas for development, looking at the way these affect internal actors and state decision-making, given manifold variables like geography and resource allocation, division of political power among interest groups, or ethno-religious pluralism, presents a more intricate understanding of globalization and conflict.

The Effects of Globalization and the Free Market Democratic Ideal

The phenomenon of globalization in worldwide markets and political systems, which has been hailed as a beneficial force of economic efficiency, international trade, income growth, and development, also brings with it costs associated with the unequal distribution of wealth in society that is inherent in free market operations. In this week’s readings, Patrick J. McDonald, Kevin Sweeney, and Amy Chua examine these costs and pressures of globalization on interactions between domestic markets and politics. While McDonald, Sweeney, and Chua differ in the scope of their examination and in their conclusions, McDonald and Sweeney examining the effects of globalization on state foreign policy and Chua examining the effects in the domestic society, the results of the three authors bolster one another’s to create a more complete overview of the effect of neoliberal, democratic globalization on domestic and foreign aspects of global markets and politics, highlighting the impact of globalization on the interaction of society and state.

McDonald and Sweeney challenge the traditionally held notion of commercial peace that economic interdependence by way of trade volume determines the likelihood of peace in “The Achilles’ Heel of Liberal IR Theory? Globalization and Conflict in the Pre-World War I Era.” They focus on the years preceding the World War I, marked by robust international trade but high protectionist measures, to substantiate their argument that national foreign policies dictated by domestic politics, rather than trade volume and economic interdependence, determine the likelihood of peace and military conflict. McDonald and Sweeney assert that “[b]ecause international trade redistributes income within society, it simultaneously creates conflicting pressures for and against more open commercial policies” (375) and that the “the outcome of a domestic struggle between free traders and protectionists within a society shapes the willingness of government to defend national interests with military force” (376). Thus, the actual policy outcomes and the likelihood of military aggression are determined not by economic interdependence but by the domestic political struggle between groups advantaged and disadvantaged by international trade and globalization. Furthermore, McDonald and Sweeney assert that states utilize this domestic struggle to garner domestic support in commercial policy to implement the states’ desired foreign policy (376-377). The effect of globalization, then, is that it creates wealth disparities that lead to a divergence of policy preferences within a society, creating a domestic situation in which economic groups engage in political struggle to influence state economic policy and the state utilizes this struggle to gather support for its national agenda in the international arena.

Chua examines the effect of globalization and the spread of free market ideals and democratic political systems on interactions and tensions between ethnic groups within a society in her book World on Fire: How Exporting Free Market Democracy Breeds Ethnic Hatred and Global Instability. She highlights the tension between democracy, markets, and ethnic hatred that arises from a combination of colonialism and the proliferation of economic neoliberalism and democratic state systems. The implementation of the free market democratic system in the non-Western world, she finds, often creates an antagonistic social dichotomy: market-dominant minorities, ethnic minorities who overwhelmingly dominate and control the domestic market and wealth, become targets of “ethnic envy and hatred among often chronically poor majorities” (9). Chua argues that “the global spread of markets and democracy is a principal, aggravating cause of group hatred and ethnic violence throughout the non-Western world” (9), explaining that“[m]arkets concentrate wealth, often spectacular wealth, in the hands of the market-dominant minority, while democracy increases the political power of the impoverished majority. In these circumstances the pursuit of free market democracy becomes an engine of potentially catastrophic ethnonationalism” (6). These contradictory forces of markets and democracy brought forth by globalization incite societal and political tension between the market-dominant minorities and the poor majorities, resulting in backlash in forms of expropriation, obstruction of democracy, and violent events motivated by ethnic hatred such as genocide (10). In short, the free market ideal promoted by globalization has led to an uneven distribution of wealth by ethnic lines and the incitement of ethnic tension, and the democratic structure concurrently promoted by globalization has given the majority groups the political power to act upon this ethnic tension created by the market system, resulting in catastrophic events of violence.

Together, McDonald, Sweeney, and Chua offer powerful insights into the effects of globalization in society. Both arguments cite the tension created by the inequality of wealth distribution in free market economies as the fundamental cause of the resulting societal divide and domestic political struggle that positions groups of conflicting interests against one another. Internationally, McDonald and Sweeney posit that these domestic forces shape national political agenda as well as its foreign policies while domestically, Chua finds the political struggles between the market-dominant ethnic minorities and the poor indigenous majorities to be at the root of domestic unrest, violence driven by ethnonationalism, and the subversion of the democracy. The findings of the three authors uncovers that the forces of globalization have powerful and, at times, troubling political, economic, and social consequences in the international sphere and the domestic arena.

Predicting Military Conflict

The articles written by Patrick J. McDonald and Kevin Sweeney, and Dale C. Copeland contemplate the magnitude of globalization’s influence on peace from varying perspectives.  While Copeland focuses on the roles of interdependence and trade expectations, McDonald and Sweeney analyze tariff levels and domestic political struggles over commercial policy to best understand the conditions under which globalization promotes peace.

Through the formulation of an extensive statistical analysis, McDonald and Sweeney find as governments erect fewer barriers to international commerce or as the quantity of free trade grows, states are less likely to engage in military disputes (McDonald, Sweeney, 390).  However, the tendency of a state to engage in free trade is highly dependent on both the outcome of the domestic struggle between free traders and protectionists, and the influence of the state in this struggle whereby it builds domestic support for the implementation of its preferred policy (McDonald, Sweeney, 376).  Expanding the Stopler-Samuelson theorem (which demonstrates that protection increases only the income of the owners of scarce factors of production) to encompass commercial liberalism, implies that those who benefit from protectionist policies may support aggressive foreign policies or war to maintain their economic benefits.  Conversely, “firms that do not rely on protection to remain profitable lack any economic incentive to pay the costs associated with war,” (McDonald, Sweeney, 381).  However, it is naïve to assume that states act in a politically neutral fashion, implementing the foreign policy goals of the dominant group within society.  Governments must respond to external political constraints and the global distribution of power.  Therefore, governments actively shape the outcomes of domestic battles over globalization in order to maintain policy autonomy and ensure domestic security.  As a result, rather than exploring why higher levels of interdependence or international trade failed to prevent WWI, McDonald and Sweeney contend that government regulation of the economy, through protectionist policies, enabled such a great military clash (McDonald, Sweeney, 373).

Conversely, the role of interdependence between states is directly addressed by Copeland in his theory of trade expectations.  This theory is formulated by expanding on both the liberal and realist explanations of the causes of war.  This new theory, however, resolves the shortcomings of both the liberal and realist arguments by clarifying the notion of economic interdependence, “fusing the liberal insight that the benefits of trade give states an incentive to avoid war with the realist view that the potential costs of being cut off can push states to war to secure vital goods,” (Copeland, 6).  Additionally, Copeland’s theory of trade expectations, “supplements the static consideration in liberalism and realism of the levels of interdependence at any point in time with the importance of leaders’ dynamic expectations into the future,” (Copeland, 7).  Copeland contends that thorough consideration of the “expectations-of-future-trade” variable along with the level of a state’s dependence explains the conditions under which high interdependence will lead to peace or war. Put simply, high interdependence can be peace-inducing, as long as states expect trade levels to be high in the future.  However, if a highly dependent state expects future trade to be low due to the policy decisions of the other side, then the state will have a low or negative expected value of trade, making war an attractive alternative if its value is greater than peace (Copeland, 17).

If one were to consider all the potential variables involved in a state’s decision to initiate conflict: level of Democracy, regional differences, hegemonic power, great-power peace, number of contiguous nations, domestic economic conflict, ideological differences, protection levels, access to food and natural resources, etc., it may seem that the trade expectation theory, involving only two variables, falls short of a truly comprehensive analysis capable of determining the probability of war.  However, the broad, yet simplified nature of the theory, in fact, allows it to account for all of these variables by absorbing them into either the “expectations-of-future trade” variable or “dependence” variable.  It can, however, be open to interpretation just how much weight each factor should contribute to a given variable.  For example, the presence of a hegemon, according to the Hegemonic Stability Theory, promotes free trade.  Therefore, the role of Britain as the hegemon in the years leading up to WWI can be seen either be seen as providing a positive contribution to state’s expectation of future trade since there was in fact a hegemon, or a negative contribution to expected trade since Britain was beginning to decline after 1873 .  However, if one disagrees with the role of a hegemon in international trade altogether, this factor would have no impact on states’ expectation of future trade.  Therefore, although the trade expectation theory does provide a functional framework for predicting potential aggression or continued peace, it lacks a systematic way of evaluating every potential factor involved in the values of dependence or expectations of future trade.    Still, the ability to consider numerous causal factors of conflict with the expectation of trade theory allows for a much better explanation for state aggression than the statistical analyses of McDonald and Sweeney.