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The US and China – A Fatal Dependency?

June 24, 2009

 The US and China - A Fatal Dependency?

The collapse of Lehman Brothers last September triggered an unravelling of the global economy so swift that its cause and scope was beyond the comprehension not only of a bewildered public but of most politicians and financiers too. Since that time, jobs have been junked, global trade has slumped spectacularly and governments across the globe have borrowed unimaginable sums to shore up our ailing economies. The implications are so colossal that we know not yet their true cost.

It is the crucial relationship between the world’s biggest economy, the United States, and its eastern pretender, China, which we should examine if we are to understand the broader reasons why this unravelling has occurred. This relationship has for many years driven globalisation and has the potential now to wound that same project fatally. For a decade or more, the United States (along with the UK) has pursued a model of growth based on debt-fuelled consumption, the cash and cheap goods provided courtesy of China. Pursued to its limits, this relationship has become dangerously unbalanced, the myth of its sustainability brutally uncovered as the complicated financial mechanisms that hitherto propped it up, dramatically collapsed.

The consequences of this imbalance are not yet fully apparent. Their impact is still difficult to predict. What looks certain, however, is that the change will be profound and troubling. The West’s position in the world may never be the same again.

In the 1970s and 1980s, Wall Street received a number of breaks, beginning with the dollar’s link with gold being broken by the Nixon Administration’s repudiation of Bretton Woods. Later Ronald Reagan ended capital controls, the global bond market expanded and the US economy was liberalised, opening up America’s savings and pensions. With US pension funds ballooning, Wall Street for the first time had access to a huge new source of finance which it sought to invest to maximum value. Corporations were encouraged to invest globally, exploit new markets and demand highest return for their shareholders – often the ordinary America pension holder.

Alongside this came a ‘hollowing out’ of US manufacturing industry as companies looked abroad for cheap goods and labour. Similar trends were afoot on these shores. By the middle of the 1980s, the American manufacturing sector was increasingly taking advantage of competitively priced, non-unionised foreign workers by moving production abroad. This process only accelerated once the end of the Cold War introduced millions more workers to the global economy. Whilst the working classes of America were invariably the losers of this deal, politicians made the case that the benefits to the US would outweigh their collective plight. New employment would be found in services, technology and the like, workers would be ‘re-skilled’ and the vulnerable would be caught, short-term at least, by the welfare system.

China was poised and ready to take advantage of these developments. Following decades of economic darkness since the emergence of Chairman Mao, the more pragmatic regime of Deng Xiaoping adopted an ‘Open Door’ policy in the late 1970s. The country moved away from command socialism and concentrated on developing strategic industries with a global market in mind. The United States happily paved the way for further Chinese integration into the global economy, culminating in China’s eventual admission to the World Trade Organisation in 2001. This final step was partially aimed at shrinking the trade deficit between the two countries. In reality, that deficit ballooned. Whilst China did liberalise and open certain sections of its economy, it kept the door to its domestic market firmly closed. By casting aside the established rules of free trade, China became the overwhelming beneficiary of globalisation, exploiting western markets whilst reinforcing its role at the centre of a powerful Asian market bloc. It simultaneously built up its own internal market and service sector, accrued vast reserves and began to secure stakes in strategically important commodity corporations and those which agreed to transfer technological know-how.

By the late 1990s, the income of the average US citizen had begun to stagnate as the hollowing out of Western economies continued apace. To disguise this unpalatable problem, politicians in the US (and here in the UK, its most closely related economic cousin) eagerly took advantage of the low inflationary environment provided by cheap Asian labour. They turned to a high consumption economic model fuelled by debt (often racked up against Chinese reserves) in the private and public sector. With easy credit and cheap mortgages, US and UK individuals were able to borrow cash as never before, the false perception of wealth embedded by access to cheap Chinese goods. Meanwhile financial services in the West thrived to manage the seemingly insatiable demand for new investment instruments.

For politicians in both America and China, the relationship between the two countries this seemed a classic case of win-win. In the US, citizens could enjoy cheap money and cheap goods. For China, the immature manufacturing sector boomed as hungry Western markets were exploited. For sure, even in the late 1990s there were nagging doubts about the sustainability of this arrangement. But to rectify them would cause short term economic difficulties and get politicians into hot water with angry voters. Furthermore, the United States was still in the driving seat. It would always be able to dictate the terms of its relationship with China…or so we thought.

Make no mistake, China will not emerge unscathed from this global recession. A slump in demand has already led to extensive Chinese unemployment. Social upheaval may follow. Given that China relies heavily on a healthy US consumer, it is conceivable that the unbalanced, but overly dependent relationship may yet develop into a tight economic alliance. Nevertheless, China remains on a growth trajectory that seems set to take its economy past that of the United States by 2050. The US Treasury and its ailing banks have been stabilised by Chinese loans. The US market remains dependent on cheap Chinese imports. It is hard not to conclude that in truth China holds almost all the cards when negotiating the terms of its bargain with America. What is more, its ascendancy – and that of near neighbour, India – may only just be beginning.

Last year, as the financial system collapsed at breathtaking rate, US and European banks and governments quickly borrowed colossal sums to shore up their operations. In large part that borrowing was funded by China’s vast surplus. In this way, a trend that was already in motion – a shift of economic power eastwards – has been markedly accelerated.

The legitimacy of western capitalism has always been bound up in the idea that it can best deliver prosperity to the masses, offering many millions a route to middle income stability each year. But as jobs and money have been sucked eastwards, that mass prosperity – for the West at least – may no longer be guaranteed. The wealth of the past two decades is increasingly being regarded as an illusion and the competitive edge the US and Europe have over China and India in services, technological development and scientific research may just as easily be taken from us. China is churning out millions of industrious, well qualified engineering and technology graduates. As it controls stakes in so many western corporations, it is also able to transfer and copy intellectual wealth with ease. Soon the powerhouses of Asia could be undercutting western labour not only in manual but also white-collar and the most highly qualified management positions.

So what will China do with the strong hand it has engineered? Many naïvely assume that along the path towards economic superpower status, China will inevitably become more open, democratic and western. We assume (or perhaps hope) that it will abide by the western ideals which have shaped the world’s international institutions and laws. It will play by our rules. But all these notions betray a fundamental misunderstanding of how China operates.

Westerners have confused the material wealth brought about by access to cheap credit and cheap goods as a physical demonstration of superiority over the world. However the debt that has been accrued by the West has come at a cost both in terms of future economic health and, more importantly, global influence. China has played – and continues to play – a patient game. Not for that country the quick fixes and instant gratification inevitably pushed for by western democracies. Instead a more patient strategy has been pursued, best illustrated by Deng Xiaoping’s ‘Twenty-Four Character Strategy’ – observe calmly, secure our position, cope with affairs calmly, hide the extent of our capacities, bide our time, maintain an assiduously low profile, never claim leadership and make some contributions apparently from the sidelines.

It is inconceivable that China will not now seek to exercise its muscle on the international diplomatic and military stage as a result of the strong hand that has been quietly won. In fact that power is already manifesting itself. Take for instance China’s refusal to condemn explicitly Iran and North Korea’s nuclear ambitions; its military action in Tibet despite international outcries; the continued unease in Taiwan; the influence it exercises across large swathes of commodity rich Africa from the Sudan to Zimbabwe. Similarly from the Caribbean to the South Pacific, it is systematically buying up influence at the UN amongst its smallest sovereign nations. Even under Barack Obama’s leadership, China is likely increasingly to reject US economic, military and humanitarian pressure. It will have greater success in any future competitions for resources and greater power to ignore the norms and rules of the ‘international community’.

What does this all mean for the UK? Curiously, now that the price of our national profligacy has been put into sharp focus, policymakers seem determined to return to business as usual. Further borrowing and the maintenance of historically high levels of public expenditure seem the order of the day, as government remains reluctant to prepare voters for some very inconvenient truths. With typical impatience, the media is already beginning to ask when the recession will end as it hunts for green shoots in every dark corner.

In cold reality, we must accept that for too long now we have been living way beyond our means, riding on a wave of abundant credit, low inflation and inflated house prices which have combined to create a false hope of ever rising living standards. As a medium-sized economy primarily reliant on a hitherto booming financial services industry, we will remain vulnerable for some time to come. For those middle income folk outside the gilded corridors of finance who were unwilling to accrue wealth via (largely housing) debt, the economic stagnation had become ever clearer well before the recession. Average salaries and wages have stagnated for almost a decade, a fact that has been disguised by grossly inflated asset prices. For younger people in particular, merit and hard work were no longer translating into secure, well paid jobs and affordable homes. Despite this, the past fifteen years will soon be regarded as having been the very best of times.

The long hard slog of a slow recovery will be difficult to swallow for a nation used to assuming that its debts would never be called in. British employees are owed nothing more than the Asian sweatshop worker and even the graduate-level openings of tomorrow may equally be filled in the decades ahead by qualified and hard working twenty-somethings from the East. A rapid return to sustainable economic growth cannot be taken for granted. Complacent hopes of British exceptionalism may not see us through. We might not have the money to cushion this blow as we have in the past with a generous welfare system.

In the short term, we will have to take a long hard look at the books and sharply pare down spending commitments. In the long term we must make a strategic decision as to the direction of our economy; whether to gamble our future on the possible resurrection of our financial services industry; going it alone as a beacon of dynamism, or whether to diversify our economy and – implausible as it may sound today – tie our future more firmly to Europe in the hope that the strength in numbers approach will partially shield us from the stiffest of economic competition from the East.

The recent economic demise has never been outside the bounds of possibility. History is full of banking crises, burst bubbles, periods of economic darkness. But the breathtaking speed at which economic power will shift firmly to the east is new. The fundamental imbalance in the economic relationship between the United States and China will now either cause that relationship to implode or it will be prolonged and made more acute by a continued tsunami of debt. Either way, the coming decades will likely be shaped by the emergence of an increasingly confident China keen to flex its muscle economically, politically, culturally and in short order too, I suspect, militarily.

The West’s hope that it can assume continued dominance in the ‘knowledge economy’ may prove optimistic. I suspect that within the next twenty years, it is quite likely that the intellectual property rights that have underpinned the West’s competitive advantage (licensing, patents, copyright protection) are overdue for a radical, philosophical shake-up. An ever more assertive China will argue that traditional IP structures are no more than the West’s attempt to impose its own form of protectionism to suit its particular demographic. We should not assume that the dominance of ‘our’ values in determining global trade will remain unchecked.

If there is to be a longer-term price for our collective indebtedness, it will be for the UK to watch with increasing impotence as it becomes our turn to suffer as the rules of the global trading game are changed to our detriment.