Joseph P. Quinlan is Managing Director and the Chief Market Strategist of Bank of America, Global Wealth and Investment Management, in New York. He also serves as Senior Fellow at the Center for Transatlantic Relations, the Paul H. Nitze School of Advanced International Studies (SAIS) of Johns Hopkins University. Quinlan lectures on global finance at New York University, where he has been on the faculty since 1992; he also teaches at Fordham University.

THE LAST ECONOMIC SUPERPOWER

The Retreat of Globalization, the End of American Dominance, and What We Can Do About It

By JOSEPH P. QUINLAN

The McGraw-Hill Companies, Inc.

Copyright © 2011 Joseph P. Quinlan
All rights reserved.
ISBN: 978-0-07-174283-2

Contents

AcknowledgmentsINTRODUCTION The Beginning of the EndCHAPTER 1 Globalization's ComebackCHAPTER 2 The Gathering StormCHAPTER 3 Financial Armageddon and the Retreat of GlobalizationCHAPTER 4 Speeding toward a Messy Multipolar WorldCHAPTER 5 A Handicapped Giant: Causes and ConsequencesCHAPTER 6 The Twilight of Europe and JapanCHAPTER 7 Flexing Their Muscle—The New Power Brokers in ActionCHAPTER 8 The Coming Economic Cold WarCHAPTER 9 Globalization ReincarnatedNotesReferencesIndex

Excerpt

CHAPTER 1

Globalization's Comeback

The decamping of the state from the commanding heights marks a great dividebetween the twentieth and twenty-first centuries.

—Daniel Yergin and Joseph Stanislaw, The Commanding Heights

Disillusionment can be a great motivator. Make enough people miserable, draintheir hopes for the future, sap their confidence, and the result is an idealprelude for change. During the 1970s the United States suffered two oil shocks,soaring prices, two economic recessions, declining productivity, and thedemoralizing effects of stagflation—high inflation-cum-high unemployment.Against this ugly backdrop, the political and economic scars the decade left onthe United States were deep enough to set off a global revolution.

The seminal event that started the 1970s downturn came from halfway around theworld. Up until the early 1970s, the United States had been the unchallengedleader of the free world, and times were so good after World War II that the1950–1973 period is often referred to as the "golden era." As the labelimplies, the two decades following the war were a time of strong global growthand development thanks to U.S. economic aid and leadership (a.k.a., the MarshallPlan), and the successful rebuilding of war-torn Europe and Japan. By the timethe 1970s rolled around, all the major economic players before the war hadrecovered from the ravages of conflict.

The good times ended when a group of developing nations decided to exert theircollective might against the West. On October 16, 1973, the Organization ofPetroleum Exporting Countries (OPEC) announced that it was raising the price ofoil by 70 percent. This body blow from the Middle East suddenly upended a nearquarter century of prosperity and growth for the United States and many othernations. Soaring oil prices stunned the fossil-fuel-dependent West and broughteconomic growth in the United States and beyond to a grinding halt.

In the ensuing months, prices soared, and the unemployment lines lengthened.Those weren't the only lines. Soon long lines of cars were winding into gasolinestations across the nation, an outcome of gasoline shortages. To make ends meet,many U.S. households that had grown comfortable with a single wage earner foundthey needed two incomes to keep up with the rising price of food, energy, andother staples. Relatively tame over the 1960s, the U.S. inflation rate surgedfrom 3.4 percent in 1972 to more than 12 percent by 1974. Not surprisingly,investors took fright of the shifting economic landscape, and by the end of thatyear, the Dow Jones Industrial Average was down by roughly 40 percent from thelevels at the end of 1972.

In such an environment, the misery index—a figure that simply combines therate of inflation with the unemployment rate—gained national prominence.The index spiked to nearly 18 percent in 1975 as prices continued to soar andthe number of idle workers increased. Jimmy Carter pounded the point over andover during the campaign of 1976, helping him win the presidency.

Popular discontent stoked skepticism over the government's role in themarketplace, undermining support for government management of the economy.Strict industry regulations, wage and price controls, state-owned enterprises,and various industrial policies—these state-led initiatives werediscredited as the 1970s dragged on. The Nixon presidency would be remembered bysome as the "last liberal administration," a rap on its aggressive pursuit ofwage and price controls and the creation of new government agencies like theEnvironmental Protection Agency and the Occupational Safety and HealthAdministration. The administrations of Presidents Ford and Carter did not fareany better when it came to creating the environment for real economic growth.Taken as a whole, the 1970s turned out to be the weakest decade of growth in thepost–World War II period.

Worse was to come. A second oil shock erupted in 1979, after Iran, a major oilproducer, was taken over by religious fundamentalists. The flow of oil from thecountry was halted, and even when the oil spigot opened again, the flow wasintermittent. The U.S. economy was staggered yet again. The misery index reachedan all-time peak of 20.36 percent in 1980. President Carter found the tablesturned on him that year, when Ronald Reagan also found the misery index aconvenient rallying cry. Rarely had a decade started on such a sour economicnote. And the pain lingered. The U.S. economy contracted in 1980, faintlyrecovering the following year before sliding back into recession again in 1982.

The point of maximum pain came in November of that year, when the employmentrate soared to a postwar record of 10.8 percent. Not since the end of World WarII had so many Americans been on the dole. And not since the end of World War IIhad the U.S. economy taken such a hit, with the economy contracting by nearly 2percent in 1982. Against this backdrop, the championing of state-directedprosperity had reached a point of no return. Times were ripe for change.

THE SHIFT IN THE COMMANDING HEIGHTS

A silver lining would emerge from the miserable performance of the U.S. economyin the 1970s. The rocky times spawned a new mindset about economic policies notonly in the United States but also in Europe. The 1980s brought a new way ofthinking about the role of the state in the economy. In the most basic terms,market failures could be blamed on government failures. A consensus formedaround the idea that governments and bureaucrats were no longer capable stewardsof the economy. That idea opened the door to a radical rethinking about therelationship between government and the marketplace. The new cause needed a flagbearer and it found two: Margaret Thatcher and Ronald Reagan. As Reagan wouldfamously remark, "The best minds are not in government. If any were, businesswould hire them away."

Starting in the United Kingdom, swiftly embraced in the United States, andadopted to some degree by key countries around the world, control of the mostimportant components of the economy, or the "commanding heights" as VladimirIlyich Lenin put it, shifted in a way that would have made the communist leaderred with anger—from the state to the private sector. Starting in the early1980s, a counterrevolution kicked in—policies were crafted that favoredthe deregulation of domestic industries, the privatization of state enterprises,and the liberalization of international trade and investment. During this eragiants in the telephone and airline industries in the United States werederegulated, while across the pond Britain privatized British Telecom andBritish Gas. Smaller government was the rallying cry, entailing lower tax ratesand less regulation. Beginning in the early 1980s and continuing through the1990s, free-market capitalism was gradually embraced, cross-border capital flowssoared, global trade and investment flourished, and globalization made astunning comeback.

The global economy set the course for a quarter century of almost unprecedentedprosperity following the severe economic downturn of the early 1980s. Around theworld, increased competition, greater cross-border openness, privatization ofstate enterprises, and industry deregulation became guiding economic norms. Thedeveloped nations—with the United States at the forefront—led theway in promoting the primacy of the free markets. In heavily state-run parts ofthe world, socialists and communists alike joined in jettisoning the "visiblehand" of the government for the "invisible hand" of the markets. Privatizationand deregulation meant the hiving off of hundreds of businesses that used to begovernment-owned or government-controlled. State-owned banks, utilities, steelmills, and other companies were all put up for sale around the world. Theeffect, broadly speaking, was to greatly reduce the involvement of the publicsector in the economy.

Led by the United States, the global economy was woven together by rising cross-bordertrade, investment, and capital flows. At first, globalization's returnrested on deepening cross-border ties among the United States, Europe, and otherdeveloped nations—or the West. Beyond the developed nations, however,globalization's roots gradually spread to other countries and regions of theworld. China's tilt toward the West in the late 1970s would gradually unlock oneof the largest markets in the world. Under Mikhail Gorbachev, political opening(glasnost) and economic restructuring (perestroika) took hold in the SovietUnion, eroding the underpins of the Communist Empire and helping to bring theBerlin Wall crashing down in 1989. Since the weight of failed communist bloceconomic policies had brought Eastern European satellite countries to ruin, mostof them eagerly embraced the principles of the free market. Under the pressureof its declining balance of payments, India revamped its inward-looking economicpolicies in 1991, gradually freeing its state-run industries from the onerousrestrictions imposed by the state since its 1947 revolution. Various LatinAmerican countries reformed their economies during the 1990s, most notablyBrazil as it broke free of military dictatorship. Around the world, free-marketcapitalism emerged superior to the bankrupt socialist model.

By the end of the 1990s, the second great age of globalization was in fullbloom. In order to understand why it was the second, some historical perspectiveis needed. The first age of globalization had occurred during the period thatstretched from 1870 right up to the eve of World War I. This was a period ofbuoyant global growth, robust trade, and strong cross-border flows ofinvestment. Money flowed freely around the world, although most of this capitalflowed from the United Kingdom, France, and Germany to less developed nations inthe Americas, Asia, and Africa. As pernicious as imperialism was, trade for thefirst time spanned the globe at a level that far surpassed all that had comebefore. John Maynard Keynes famously captured the mood of the times with thispassage from his Economic Consequences of the Peace, penned in 1919:

What an extraordinary episode in the economic progress of man that age was whichcame to an end in August 1914! The inhabitant of London could order bytelephone, sipping his morning tea in bed, the various products of the wholeearth, in such quantity as he might see fit, and reasonably expect theirdelivery upon his doorstep; he could at the same moment and by the same meansadventure his wealth in the natural resources and new enterprises of any quarterof the world, and share, without exertion or even trouble, in their prospectivefruits and advantages; or he could decide to couple the security of substantialmunicipality in any continent that fancy or information might recommend.

World War I, however, would end the first age of globalization, and nor wouldglobalization be revived after the war. Europe, the main agent of the firstflowering of world trade, was too indebted to the United States to do much morethan scramble to stay afloat, and the United States largely turned its back onthe world. The economic shocks in Weimar Germany would keep the rest of Europeuneasy, and the U.S. stock market crash in 1929 sounded the death knoll of whatwas remaining of the era's economic expansion. The disastrous run on majorEuropean banks that followed in 1931 and collapse in global trade would plungethe world into depression. While the U.S. economy expanded by more than 40percent between 1933 and 1937, tax increases and spending cuts helped push theeconomy back into recession in 1938. It was World War II that ultimately pulledthe world out of recession, with the United States emerging as the leader of thecapitalist world. Seizing upon their imperialist masters' weakness, Europe'sfar-flung colonies, through riots and armed struggles, would fight their way toindependence in the decades following the war.

In the rise of the second age of globalization, those colonies have becomeintegral players in the expansion of world prosperity. The holy trinity ofderegulation, privatization, and trade and investment liberalization has raisedworld output, bolstered global trade and investment, and lifted millions out ofpoverty in India, China, and other developing nations. The economic numbersvividly illustrate the tale. Between 1983 and 2007, the global economic pieexpanded from roughly $12 trillion to over $55 trillion. World exports of goodsand services soared from $2.2 trillion to over $17 trillion during the sameperiod; reflecting the deep nature of globalization, world merchandise exportsas a percentage of world gross domestic product (GDP) hit a postwar peak of 26percent in 2008. The stock of outward foreign direct investment surged from $616 billion in 1983 to over $16 trillion in 2007. Meanwhile, per capita incomesin the developing nations gradually rose, notably in developing Asia and partsof Latin America. Global stock market capitalization surged from $2.2 trillionin 1985 to a peak of nearly $59 trillion in October 2007. Numbering just around20 in 1990, the number of stock markets in the developing markets topped 68 in2009.

This era of prosperity has been marked by bumps along the way, to be sure.However, recessions in the United States became less frequent and shorter induration. Periodic financial crises came and went without much lasting damage tothe forward momentum of globalization. The Mexican peso crisis in 1982, the U.S.stock market crash of 1987, the U.S. savings and loans crisis in the late 1980s,the concurrent boom and bust of Japan's property market, and the 1997 Asianfinancial crisis—all these events roiled the financial markets at the timebut were quickly brushed aside as one-off events. By the 1990s, so fine-tunedwas the U.S. economic growth engine that many on Wall Street talked of the"Goldilocks economy," or an economy not-too-hot, not-too-cold. Others spoke ofthe "great moderation"—or a propitious backdrop of steady economic growth,low inflation, and infrequent recessions. This relative calm was quite differentfrom the stagnant growth-cum-rising prices of the 1970s, and given this radicalturn of events, the consensus was that free-market capitalism was the bestwealth-generating system ever concocted, with the Anglo-Saxon model at theforefront.

As part of this consensus, the battle between the state and the marketplace wasunequivocally over, and the marketplace was declared the clear winner. Indeed,so decisive was the shift in "the commanding heights" that in the last decade ofthe twentieth century, experts began predicting the end of the nation-state andgovernments subordinated to the markets. Francis Fukuyama famously proclaimed"the end of history." So powerful were the market forces sweeping the world thatany state or government that stood in the way would ultimately end up as "roadkill."

Underlying all of globalization's success was one vital ingredient: theunfettered cross-border flow of capital. To understand how capital wasunshackled from the chains of regulation in the 1950s and 1960s, one has to goback further than Thatcher and Reagan. A better starting point is with a mostunlikely revolutionary: Richard Nixon.

THE FOUNDING FATHER OF MODERN GLOBALIZATION

The legacy of Richard Nixon is replete with seminal events—the VietnamWar, détente with China, and of course, the deception of Watergate. Nixon'slegacy, however, is rarely associated with the advent of globalization and therise of the free markets. Yet Nixon's decision on August 15, 1971, to abandonthe gold standard—effectively ending the Bretton Woods system put in placefollowing World War II—would set the world economy and financial marketson a different path in the ensuing decades. As Martin Wolf of the FinancialTimes pointed out, "The abandonment of the Bretton Woods system of fixed,but adjustable, exchange rates in the 1970s marked the beginning of a new globaleconomy." In effect, financial globalization was born.

Prior to Nixon's momentous decision, the U.S. greenback acted as the world'sreserve currency. The buck was backed by gold, meaning that the United Stateswas committed to exchanging gold for dollars at a fixed rate of $35 per ounce.For a quarter century this system had worked very well. Along with the rise ofthe West came the expansion of global multilateral institutions that promotedglobal trade and investment, including the World Bank, the InternationalMonetary Fund, and the General Agreement on Trade and Tariffs (GATT).

The system worked as long as foreign claims matched the size of U.S. goldreserves. Late in the 1960s, however, the fixed exchange rate came underincreasing strain. Rising government spending on the Vietnam War and the costsassociated with the Great Society program of the Johnson administration stokedinflation and encouraged speculative attacks on the dollar. Efforts were made byboth the United States and its trading partners to shore up the dollar but to noavail.

As Europe and Japan healed from the ravages of war, they made rising exports tothe United States the key to their recovery, and as a result their dollarholdings gradually exceeded the U.S. stock of gold. This important shift, alongwith rising inflation, slowly eroded confidence in the U.S. dollar and America'scommitment to the Bretton Woods system. The system rested on the belief that thedollar's value was "as good as gold." But in 1971, the United States posted itsfirst annual trade deficit since World War I, sparking fears about America'sdwindling gold reserves and loss of global competitiveness. With the politicaland economic costs mounting, President Nixon capitulated in August 1971 by"closing the gold window," thereby effectively ending the Bretton Woods system.

At the same time, Nixon imposed a temporary surcharge on a host of imports, butneither the downward adjustment in the U.S. dollar (with the dollar declining byroughly 10 percent a few months after the buck was delinked from gold) nor thetax on imports did much to improve the competitiveness of the United States.While the U.S. trade balance swung to a modest surplus in 1973, the pendulumswung in the other direction the following year thanks to the spike in world oilprices and the attendant jump in U.S. oil imports. The United States posted atrade deficit of $4.3 billion in 1974, beginning a string of annual tradedeficits that continues virtually uninterrupted to this day.

The disintegration of Bretton Woods ushered in a new world of floating exchangerates and greater cross-border capital mobility—a vastly different worldfrom the tight controls after World War II. For more than two decades, theglobal capital markets had remained "caged." That is how the chief architects ofBretton Woods—Britain's John Maynard Keynes and America's Harry DexterWhite—wanted it. Both men believed that capital controls were required tohelp eliminate the economic volatility and financial anarchy of the yearsbetween the two world wars. The Great Depression had spawned an extensive web ofglobal capital controls as one nation after another attempted to insulatethemselves from the economic wreckage around it. Trade and overseas capital wereheavily regulated; indeed, by the eve of World War II, according to the WorldBank, global capital flows had dried up.

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