Does the “Hyper-Power” Have Feet of Clay?

MEDFORD, MASS: If the terrorist attacks of September 11th ended America's sense of invulnerability, they have not muted the breathless talk of the US as a "hyper-power." As the US is about to embark on an audacious venture in Iraq, it is seen by many as an arrogant global superpower, destined to call the tune because of its military, technological, and economic strengths. A long-term view, especially of America's economic vulnerabilities, might lead one to a very different conclusion.

There is a natural tendency among analysts in stock markets, economics, and politics to look at the past year or several years and expect that recent trends will persist. It may be useful to remember that in the 1980s, when Japan was growing rapidly, it looked unstoppable. The peak in popular perceptions of inevitable Japanese economic suzerainty was probably in the late 1980s and early 1990s, just as the bubble was collapsing. Likewise, though to a lesser extent, South Korea was being hyped as a rising economic giant just as its conglomerates were getting into deep trouble and about to collapse. In both cases, there was a long period of solid and even spectacular progress that was real. However, by mainly or only looking at the successful elements, vulnerabilities were ignored or minimized.

A similar error is being made in assessing the strength of the sole superpower. Obviously, the US has many strengths, and they are significant ones. Its military is without peer, far and away the most capable. This is likely to continue for some time, although the threat of "symmetrical" warfare could create a new kind of balance of terror that even its military finds hard to deal with. If war is an extension of politics by other means, the ability of non-state or semi-state actors to inflict extensive damage may well change the political calculus.

But it is in the economic sphere that the vulnerability of the US is most acute and seldom discussed. The newly emergent fiscal deficits alone could become a significant burden as social security and medical care costs for the elderly skyrocket in a few years. Spending is hard to control and easy to increase, even for Republicans. If a continued policy of using tax cuts to control spending is used, the results could be disastrous. Many commentators have noticed the large US current account deficits and for some years have predicted the dollar would weaken. It finally has fallen, but even its descent to this point has left it above the point where the Euro started trading. If this is the price of reckless spending, it hardly seems condign punishment.

In fact, the US has a real structural problem. Neither the EU nor Japan seems likely to grow as fast as the US in the next several years. Their native population growth is near zero and will turn negative. They resist immigration relative to the US. Their participation rates (share of working age people working) are low and their unemployment rates high. Innovation is difficult due to various rigidities in labor and capital markets. Unless this changes fairly soon, it will be difficult to grow steadily much over 2% a year, while the US growth is likely to be closer to 3% a year. Growth means imports, and the US has been and will tend to see its imports grow faster than its output. So will the EU and Japan, but this will be very much less. ¹ Adjustments from Canada, Latin America or non-Japan Asia will not make enough of a difference to solve the dilemma. The US now needs over $1.3 billion in capital inflow each day to finance its import appetite. This makes it highly dependent on those with excess savings, now largely in Asia. A slowdown in foreign inflows for economic or political reasons would be crippling.

Defenders of George W. Bush question this picture of US vulnerability. One argument is that deficits do not matter and that US growth reflects opportunities for investment, and both sides are better off for the capital flows. Another is that the dollar will fall enough to equilibrate the demand and supply for foreign currency. A third is that the problems of the EU and Japan are really opportunities, and that reforms could eliminate these problems and unleash a period of growth that would drive up their imports.

The "deficits do not matter" people can be right until they are wrong. If a nation relies heavily on capital inflows, it can benefit if the inflows are used for efficient investment. However, recent US investment ratios, at 16% of gross domestic product or total output, are not especially high. A decision by foreigners even to slow the rate of capital inflow by reducing the rate at which they buy shares and bonds would put immense pressure on the dollar. Sustaining deficits of 4-5% of GDP is unlikely. There will be an adjustment. The question is of what kind and how soon it will occur. Likewise, there is no question that the dollar would fall if inflows no longer supported current import deficits. The question is how much would it fall, and what impact would it have on the economy, inflation, and financial markets.

Of course, there is some value of the dollar at which a shrinking trade gap and rejuvenated capital flows would reestablish a balance. A cheaper dollar would reduce US imports, help its exports, and make US assets more attractive. But this value might cause significant dislocations in bond and credit markets, a rise in inflation, and depressed export industries abroad. (Indeed, it is the fear of losing export competitiveness that drives China and other nations to peg their undervalued currencies to the dollar, helping to prevent a smoother adjustment.) If the experience of other nations is any indication, it is not a good thing for the depreciating country or for the world economy to have a sharply falling major currency. Exercising world power as a debtor with a highly devalued currency would be difficult.

The third argument - that poor policies eventually change - is probably right but has a very uncertain time frame. The demographic pressures weighing on both Japan and Europe are much stronger than in the US. Attempts to reduce the pension or welfare burdens, both clearly unsustainable, are fiercely resisted. This political inaction caused by popular resistance to necessary cuts leads to stagnation, as taxes rise and current production is overtaxed. Growth has been slower, even though their investment to income ratios have been higher than the US. Meanwhile, Asian investors have been buying US assets. But if they began to believe that this was not profitable due to a falling dollar, it is much more likely that the dollar would adjust before the EU and Japanese political systems did.

If, indeed, the US faces a weaker dollar and difficulty financing its usual levels of investment without foreign funds ² , it can scarcely be said to be a superpower in any comprehensive sense. It will be functioning well only to the extent that others support it by buying its real and financial assets. Without these inflows the US would find it more difficult to keep its technological edge, to attract bright people, and to maintain its productivity growth. Investment and government spending would have to be cut to reflect the lack of foreign inflows. High interest rates would undermine construction, stock prices, and especially the automobile industry.

A final argument against this picture of US economic vulnerability is that it is the US multinationals that control much of the exports sent to the US and so the benefit, even if hidden by tax shelters ³, goes to US based companies. First, it is not clear to what extent this is true nor if it will be continue to be true. Second, much of the US technical edge relies on patents or copyrights that are often ignored or reverse engineered. While legal action might save some US profits, it is hard to see generic drugs being outlawed in many countries, or cheap switches and routers being shunned because of legal questions by Cisco Systems. Third, many of the top US exports such as microprocessors or jet aircraft face falling revenues - not just prices - or effective challenges from (possibly subsidized) foreign competition.

No nation can dominate for long when its very economic health, much less its ability to project power, is based on the cooperation of those supposedly dominated. Even without any political effort, the size and likely structural nature of US deficits will require a large and perhaps sudden decline in the value of the dollar. This decline will impose adjustment costs such as rising unemployment and falling asset prices on both the US and other nations. If nations currently keeping their currencies undervalued started to diversify away from dollar assets, the change might start sooner and cause less dislocation. Certainly the US needs to take steps to improve the competitiveness of its tradable sector - exports and import competing goods. Without greater economic strength, the future of US hegemony is likely to be either shorter or more nuanced than either the friends or critics of the US realize.

1 Japan, for example, saw imports rise from $217 billion in 1990 to $313 billion in 2001, a gain of 45%, which is much more than the rise in its GDP valued in dollars. However, much of this growth was from Asian nations producing for Japanese companies. Exports from the US to Japan in $ actually fell from 1995 to 2002, and were little changed since 1990! Likewise, Western Europe's imports from the US rose by less than 40% while US imports from Europe rose 150% from 1990 to 2002.

2 In 2001, US investment was $1646 (16% of GDP) billion and the trade deficit was $349 billion or a ratio of over 20%. This ratio is rising. A cut of over 20% in investment would have considerable impact.

3 Corporate taxes have been falling as a share of total US revenues and are now only 8% of total taxes if payroll taxes are included in total revenue. They exceeded 20% in 1960 and 10% as late as 1989.