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- The New Rules of the Global System
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In the first part of this piece, I wrote about the prospects for various parts of the world now that the gloves are coming off. The election of Trump didn’t start this process but it will significantly accelerate the breakdown of the old geopolitical order. I used the movie The Hunger Games as an analogy to understand the coming war of each against all.
But as I said in that piece, I think The Hunger Games will evolve similarly to the subsequent movies. Eventually some group of the contestants will gang up together to take the Capitol and end the games. The US is the main power that can do this and I’ll explain how.
How Did We Get Here?
First let’s baseline why the old order is coming to an end. The US constructed a system post World War Two focused on fighting the Soviets. The main theater for that battle was in Europe. The US needed allies to help in the fight and most of them were crippled after decades of conflict, financial crises, and war. The US allowed countries to export to the United States to build back their economies. It provided protection to international trade and the world economy grew.
After the defeat of the Soviet Union though, the need for the US to provide markets for its allies and the justification for the security umbrella it had constructed started to erode. However, while the system the US had constructed no longer made much sense, it had created powerful advocates within the US. Wall Street benefited from the financial inflows necessary to keep the dollar strong and the national security state got used to the power that having the US dollar as the global reserve currency provided.
Once China joined the world trading system fully in 2001, the ultimate collapse was all but guaranteed. The US foolishly allowed China to use the system it had constructed to grow into a new strategic competitor. Given the size of its economy and the fact that it was not within the US security umbrella and alliance system, China was not amenable to previous patches to the system like 1985’s Plaza Accord.
We now find ourselves in a situation in which the US must run large deficits to accommodate the surpluses of China and Germany and to a lesser extent Japan and South Korea. As the US share of world GDP declines and each of the next three largest economies runs ever larger surpluses, this situation is becoming untenable.
Unless China and Germany adjust their economies, the US will be forced to either run even larger deficits while what remains of its manufacturing base further erodes, accept much higher unemployment, or restrict access to its markets or currency.
What Are the Options?
The US must take the lead to reshape our global system. We can do this in several ways; some more cooperative and others more punitive.
Option One: Rosy Scenario. The best option would be for the US to call all the leading Nation’s together to hash out a plan to adjust global imbalances and reform the trading system collaboratively. This would require countries like China and Germany to shift their economies to be more consumption led and would involve a new system of capital controls to ensure currencies can’t be manipulated lower to spur exports.
I see the chances of this happening as approaching zero. China’s adjustment would require the Communist Party to delay its transition to technical preeminence and it would force massive layoffs at State Owned Enterprises to shift export-focused production into more service oriented jobs. China would have to transition workers making EVs to become providers of home heath care services. That’s not an easy transition and it is likely China’s authoritarian system would break down as a result. As I wrote in The Wraith of Xi, China is dead set on owning the technology of the future and employing its people in the effort.
Option Two: Coalition of the Willing
In option two, the US would keep the existing system and institutions intact as much as possible but it would work collaboratively with its allies to box out China. The US would likely allow Japan, South Korea, Germany, and other allied countries to continue their manufacturing and surplus led models as a way to lure them away from China. It would basically try to move us back to the pre 2000 era before China joined the WTO.
This feels a bit like what the Biden Administration favored. It’s the rosy scenario from option one but ex-China. There’s a lot to say for this option in terms of gradual change and stability but it has fundamental flaws. If everyone comes willingly to the table, the sticks won’t be available to enforce compliance. It sort of feels like OPEC. We’ll all agree to big things at a summit and then go subvert the agreements first chance we get.
Option Three: Bring the Hammer
I’ve been tracking the ideas of two key thinkers that have influence with the incoming Administration. Scott Bessent is Trump’s nominee to run Treasury. He’s advocated (see here at minute 32:30) for a system where the United States would establish an international stop light system.
Red countries would be China, Iran, Russia, and North Korea. These countries don’t comply with US foreign policy and trade goals. We’d reserve our highest tariffs and other punitive measures for them. Yellow would be countries that we might agree with on trade or on foreign policy but not both. They would get limited access to our markets and currency with incentives to shift to Green. I’d see India in this category. We like you on trade and China but don’t like you buying Russian gas and oil. Green would be reserved for close allies like Great Britain and Australia.
This is a more unilateral system but it is at least rules based. We would be explicit and allow countries to move between categories. I think this system gets into trouble with trade offs between national security and economic goals. Where would South Korea sit? It seems like a yellow on trade but we really need them in our anti-China coalition. What about India? They are even more important to our coalition. Would we really risk angering them over Russia? It could also spike inflation.
A former Treasury official from Trump’s first term, Stephen Miran, laid out another version of this system in a recent paper for Hudson Bay Capital that seeks to tame that potential inflation. It’s a brilliant and innovative paper and anyone serious in the trade and national sercurity space should read it.
I think what Miran envisions is a new American Empire built off of access to the dollar and American military protection. One of the issues we face in running large deficits is the risk that bonds markets will eventually revolt and demand higher interest rates as compensation for the risk of getting paid back by a country running ever higher deficits. Higher rates slow economic activity and make financing the debt more expensive.
Additionally if we begin applying tariffs and erecting trade barriers to reshape the system those actions will also spike interest rates as bond markets anticipate inflation resulting from less free trade. Miran suggests two ways to solve that problem. First (as in Bessent’s proposal) the US would focus on deregulating its domestic economy and on reducing the price of energy by pumping more gas and oil. Both these actions would stimulate growth and favor a more deflationary environment to offset the more inflationary trade actions.
Second, we could cut deals with our allies that would exchange military protection and trade rights for a willingness to buy long dated US Treasury bonds. He suggests that allies would buy 50 or 100 year bonds or even perpetual bonds at slightly below market rates. That would replace the private sector buyers spooked by higher inflation with long term holders.
Currently, most countries buy shorter dated bonds because they are less volatile. A country like Japan would need to sell Treasuries to buy Yen when its currency goes too low or vice versa. It wants a relatively stable Treasury price to ensure its ability to respond to its own domestic needs.
Longer dated treasuries are more risky. Miran suggests that the US establish swap lines to help with needed currency interventions during periods of stress. We already do this as a supplement to Treasury selling for close allies. His suggestion would institutionalize this practice and presumably expand it since those countries would be more reluctant to sell longer dated bonds that had declined in value.1
The proposal makes sense but there are two issues to deal with in Miran’s system. First, this is total vassalhood. Countries would essentially outsource their currency management system to the US. How many would subjugate themselves so completely? I’m not sure. Would they also expect more explicit security guarantees?
Second, would this system strengthen or weaken our allies? Buying below market assets seems like a way to weaken your allies. It would also further encourage them to skimp on military spending. That might work in Europe where we don’t really need strong allies but not in Asia where we need a strong Japan, Australia, India, Philippines, etc. to balance China.
Where Do We Go From Here?
I think we’ll try elements of each option going forward. It’ll be confusing and I think we’ll have to experiment with how far to push each approach. Overall though I see three major factors that will cut across all Administrations:
We will tie economic and national security interests closer together. To an extent we’ve always done this but it will get more direct and explicit over time. The days of Treasury and DoD inhabiting different worlds are over. The neoliberal era where decisions were supposed to be made by rational actors to maximize profit are over.
China is the focus. Both sides of the political aisle in the US are now squarely focused on China as the problem. They might employ different tactics to deal with it but they both will seek to squeeze China.
Volatility will increase. Reordering systems isn’t easy or smooth. We will have to test approaches. Some will spook markets and allies who will panic in the face of a changing trade and security environment. Many countries will soon realize their options are limited and the assumptions they have lived with comfortably for years have been exploded.
Welcome to the new rules.
Keep learning,
Alan
P.S.
1 This is very similar to the bail out of Silicon Valley Bank. It had a large book of treasuries it had purchased at low interest rates before the 2021/22 inflation. That book
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