Books Excerpt: Losing Control


By Stephen D. King

The world is witnessing a massive redistribution of wealth as the West learns it can no longer live beyond its means, says HSBC’s group chief economist Stephen D. King, author of Losing Control: The Emerging Threats to Western Prosperity.

For the Western world, major challenges lie ahead. Economic life is increasingly unpredictable and (dare I say it) unfair. Markets cannot easily resolve the key issues—economic instability, income inequality, state capitalism and demographic change—that are now confronting policymakers in both the Western and emerging nations. We are living in a highly unstable world where Western policymakers will be tempted to choose options that, while offering short-term political advantages, could be destructive for globalization and, ultimately, destructive for Western prosperity. We have reached a point where the Western world has to recognize and accept its growing dependence on economic and political ties with the emerging world. For the West to reject these ties would ultimately be damaging not just for the emerging nations but for the West as well.

The claim that Asia and, indeed, other emerging economies offer no real threat to Western economic superiority is absurd. Those who take comfort in the idea of the West’s destiny point to Japan’s stagnation since the 1990s, arguing that while Japan successfully caught up with the US and Western Europe economically, it never surpassed them, despite projections to the contrary. Indeed, in the effort to do so, it stagnated. However, Japan’s lost decades should be seen not as a relative triumph for Western economic systems but as a sign of what may lie ahead for the developed world as a whole.

Many observers also reassure themselves that the emerging world, particularly the new titans such as Russia and China, will not truly challenge the West’s dominance because they are not committed to developing open, free-market economies. But these countries benefit from openness in other ways. They increasingly trade with the developed world and with each other. They are signing bilateral deals with each other. What we’re beginning to see, in fact, is the creation of a new, global Silk Road linking emerging nations in Asia, the Middle East, Eastern Europe, Africa and Latin America via land, sea and the electronic ether. It is a new, major and incredibly important artery linking the nations of the emerging world. There may ultimately be political constraints on economic progress, but it’s doubtful that those constraints are going to be triggered in the near future: instead, we are witnessing the creation of new emerging economic synapses that will enable non-liberal-democratic political regimes to survive more easily.

The biggest threat to economic openness comes less from the emerging nations, which are beginning to enjoy their time in the economic sun, and more from the West. The US and Europe will need to come to terms with their diminished role in the world economy. No longer will their economies determine the price of raw materials. Their workers will be unable to determine the market price for their labor. Their people will not be able to pursue so easily the rent-seeking agendas that allowed returns on all factors of production in the US and Europe to rise far beyond those seen elsewhere in the world. Their pensioners will not be able to look forward to a guaranteed real income. And they will no longer so easily be able to manage their economic destinies.

How will policymakers come to terms with the West’s diminished status? The policy options available are a mixture of the good, the bad and the ugly.

The Good
One of the key issues facing the world is the arbitrary redistribution of income and wealth both within and between nations. This problem stems in part from a lack of proper regional or global institutions designed to cope with the twin, but conflicting, desires of monetary sovereignty and free cross-border capital flows. The easy answer for those who wish to satisfy both desires is to have a world of flexible exchange rates. This is not always a workable option, though, and the more currencies there are, the less likely it is that the world will continue to enjoy the benefits of a single capital market.

Policymakers have to stop the pretence and confront head-on the conflict between a single global capital market and the proliferation of nation states, many of which have their own currencies. Either nations can attempt to hang on to their financial sovereignty by reintroducing capital controls, or new institutions need to be developed that can pool financial sovereignty effectively.


The idea of dampening down capital markets through capital controls has a long and rich history and was, of course, part of the post-war international financial consensus: if countries wanted to control simultaneously their exchange rates and their domestic inflation rates, they had no choice but to regulate capital inflows and outflows. As that consensus began to unravel in the 1970s with the failure of the Bretton Woods system of fixed but adjustable exchange rates, countries slowly moved away from capital controls to the world we’re now living in. In a world of constant financial innovation, it became increasingly difficult to impose capital controls successfully. Capital controls also allowed countries to pursue bad domestic policies for too long, ultimately to their own detriment.

Enthusiasm for some kind of capital control has recently returned. In the wake of the 2007/8 credit crunch, central banks began to argue the need for two separate policy instruments: short-term interest rates to control inflation and some kind of ‘macro-prudential’ policy to limit the impact of unstable capital inflows on domestic bank lending. In the macro-prudential world, banks would be forced to put aside extra savings in the form of higher levels of capital during the years of cross-border lending feast as an insurance against the famine that was likely to follow. In other words, there would be an attempt to limit the domestic implications of cross-border capital flows by imposing the equivalent of a variable tax on the banking system.

Features_Book-Excerpt-3_03 At the global level, however, these kinds of reforms seem rather messy. If one country alone imposes them, that country might end up with some protection against the volatility induced by currency speculation, for example. In the UK’s case, a policy to force banks to raise their capital ratios during cross-border lending booms might limit the extent of speculation in the domestic housing market. If, however, all countries went down this path, it’s difficult to see anything other than the financial equivalent of the primordial soup developing: at the very least, cross-border flows of capital would drop and many countries might find themselves cut off from international capital markets altogether. Indeed, the world might descend into capital market protectionism. Whatever the problems associated with the disruptive effects of capital flows, their huge increase since the 1970s has been instrumental in raising living standards in many parts of the world.

A Lesson from Europe
One of the key issues facing the developing world is the dominance of the US dollar. As emerging markets become more powerful, their policymakers could collectively choose to do something about that dominance. Currently, US monetary decisions reach far and wide, yet the Federal Reserve has no real duty to worry about the rest of the world. For a heavily indebted US economy, persistent dollar depreciation is an attractive option. It imposes a burden on the rest of the world—a burden carried by America’s creditors. Discontent with this status quo could lead us to a world where the dollar is rejected, where the agenda of globalization is increasingly determined outside the US and where, in the steadfast defense of monetary sovereignty, globalization in all likelihood goes into retreat.

There is, however, another option. The blueprint for radical reform can be found in Europe. It’s called the European Central Bank. Its establishment left individual European nations without domestic monetary sovereignty. Germany, France, Italy and others in effect pooled their monetary interests. This was a logical extension of the European Single Market, which in 1992 had finally put an end to capital controls within the European Union.

The unusual feature of the European Central Bank, at least compared with other central banks, is that it has no fixed geographical jurisdiction. The Federal Reserve has to worry only about the 50 American states. The Bank of England needs to concern itself only with the so-called home nations. The European Central Bank, in contrast, cannot easily tell from one year to the next which countries will fall within its remit. When the euro was first formed, it wasn’t obvious that, in the years to come, Greece, Slovenia, Cyprus, Malta and Slovakia would join. Widening euro membership presents an interesting antidote to the conflict between a single global capital market and the proliferation of nation states. In effect, it reduces the monetary sovereignty of nation states while allowing them to maintain sovereignty in other areas. Importantly, those that join the euro have voting rights on monetary policy. Unlike other currency arrangements—full-scale dollarizations and various currency peg arrangements—adoption of the euro gives a country a seat at the policy table. There is some loss of sovereignty, but it is not a complete loss. Meanwhile, the trials and tribulations of currency upheavals are, at least in theory, permanently removed.

To date, euro membership is confined to members of the European Union and is contingent on countries meeting specified convergence criteria. Like any club, therefore, the euro has a strict membership policy. That policy, however, could change. European Union membership could widen further. The convergence criteria might be relaxed (in the case of Italy and Greece they were not imposed rigorously). Or, signaling a much bigger revolution, perhaps a time will come when countries not in the European Union may be able to join the euro. Imagine, for example, that Turkey joins the European Union. Turkey’s membership would signal, once and for all, that the European Union was not, as some might claim, a specifically Christian union. Would Turkish membership begin to change the nature of Europe? Recognizing this changed nature, would other countries seek to become more closely integrated in the financial aspects of the European project, even if they were geographically detached? In this very different world, it wouldn’t be so difficult imagining euro membership extending eastwards to Central Asia and to the Levant and southwards to North Africa. Indeed, such an arrangement would not be unlike the Roman Empire 2,000 years ago, where peoples were connected around the entire Mediterranean Sea. This time, however, the connections would be on a voluntary basis—an empire of equals.

If this could happen in Europe and its near neighbors, then perhaps similar developments might eventually occur elsewhere. It’s unlikely we’ll ever see the chairman of the Federal Reserve and the governor of the People’s Bank of China sitting down in the same room deciding on a common monetary policy for the US and China even though, as an economist, I could probably make a good case for regular Sino–US monetary meetings. Other associations, however, are easier to imagine. Why not, for example, have a single North American currency extending across Canada, the US and Mexico? Eventually, this new currency could spread further south, with countries in Central and South America also taking part and, in the process, receiving voting rights. After all, Panama and Ecuador are already “dollarized,” but, unlike my suggested new arrangement, they currently have no voting rights over US dollar monetary policy.

The same process, meanwhile, could happen in Asia. China is already pushing for the renminbi to have a bigger international role. Why not go one step further and create an Asian monetary union? Could China and Japan, for example, bury their differences and end up with a common currency? Might India, South Korea, the Philippines and Indonesia want to join in?

At the moment, the US Treasury and Federal Reserve seem to hold all the cards. This is not sustainable. Either countries eventually go their separate ways or they pool their monetary and financial interests, giving all those involved a seat at the table, subject to the rules of the club.

More can also be done at the domestic level. If globalization is to continue, a healthy debate over how the losers from globalization should be compensated is surely necessary. At the moment, there is too much denial, perhaps because politicians think they are impotent to act in the midst of the storm generated by the emerging powerhouses. Nevertheless, the case for maximizing growth with no regard for the distribution of that growth is fading fast: the gains are distributed so narrowly that the majority are just not benefiting from apparent national economic success. This, ultimately, is a recipe for conflict and the rise of extremist views.

Domestic reforms are, however, secondary: what matters more than anything else is establishing more stable and sustainable economic relationships between the developed and emerging worlds. Without these, domestic reforms can all too easily turn into protectionism. Improved international economic relationships require the dollar’s role to be reappraised, either as part of a grand plan or, alternatively, in the light of its growing rejection by the new economic superpowers.

The Bad
Since the end of the Second World War, the world has moved, inch by inch, towards a system of multilateral arrangements. Some of these, such as the Bretton Woods exchange-rate system, have not survived. Others, such as the United Nations, have persisted even though their strictures have often been ignored. The icing on the cake for multilateralism was, arguably, the fall of the Berlin Wall. The collapse in Soviet communism created freedoms for many countries that had previously been under the Soviet yoke. Some of these countries joined the European Union. Others joined NATO. Some joined both. Russia itself joined the G7, turning it into the G8.

These events, however, can equally be described in very different terms. The widening of NATO membership to Central and Eastern Europe is construed by Russia as an attack on its sphere of influence. Discussions about possible membership for Georgia or the Ukraine naturally create anxiety in Moscow. As Sir Christopher Meyer, the former British ambassador to Washington, notes, “The fall of the Soviet Union did not wipe the slate clean. The Russia that we are dealing with today, with its fear of encirclement, its suspicion of foreigners and natural appetite for autocracy, is as old as the hills, long pre-dating communism. It is a Russia that will never be reassured by the West’s protestations of pacific intent as it pushes NATO and the EU ever eastwards.” Put another way, the fall of Soviet communism has reopened imperial rivalries and led to the re-emergence of ethnic and religious strains, which, for so many decades, had lain dormant.

China, also, has reason to be suspicious about the new ‘multilateral’ world. At first sight, China has fewer reasons to worry about organizations such as NATO. However, NATO’s operations take place in many different parts of the world, and it is a military club for like-minded democracies with market economies. China doesn’t qualify. This immediately creates room for tensions.


Stephen D. King

We are in danger of returning to the political games of the late nineteenth century, focused on the ‘enabling resources’ of land and fuel. The spike in food prices in 2007 and 2008 led some Asian countries, including China, South Korea and India, to strike deals with leaders of African states to provide access to agricultural land, typically in return for promises regarding the development of infrastructure and logistics, both of which are severely lacking in many African nations. Whether these deals work for all involved—most obviously the local smallholders with poorly defined property rights—is another matter. Nevertheless, they can be regarded as a mechanism to safeguard food supplies for rapidly advancing Asian nations which, themselves, are facing increasing problems associated with growing water shortages and shifting dietary preferences.

Even though these deals are routinely described as land grabs, they are, in reality, no more than a minor version of the activities pursued by European nations before the twentieth century. They reveal, however, an underlying truth about 21st Century economic development. Countries will continue to prosper only if they can gain access to food and fuel supplies. Increasingly, nations are beginning to believe that the market, alone, cannot safeguard ongoing prosperity. Bilateral deals are becoming commonplace, creating for some countries privileged access to resources that may, as a consequence, be in short supply for others. If this is a new colonialism, it comes as no surprise: it’s merely a response to economies bumping into domestic resource constraints. It also suggests we can expect an increase in non-market outcomes when it comes to the allocation of scarce resources.

Of course, it’s quite possible that bilateral deals will lead to productivity advances which, in turn, will have a hugely positive effect on, for example, agricultural production, boosting supplies to such a degree that food prices will fall rather than rise. In those circumstances, worries about food security would surely begin to fade. Thus we may be heading towards a world of smoke-filled rooms, questionable deals struck behind closed doors and the renewed rise of economic nationalism.

Features_Book-Excerpt-3_03 In a world of bilateral deals, Asia’s voice will become much louder. Why should Russia sell its gas only to Europe when it will also benefit from a rapidly expanding market to its east? Why should Brazil worry too much about US demand for its metals when the key marginal consumers will be coming not from the North Atlantic but on the other side of the Pacific? How will the US continue to exert influence in the Middle East if some of the key players—such as Iran—are able to become increasingly cozy with China, Russia and other countries to the East.

Whether or not we see a return to bilateral deals, it’s likely that patterns of trade will continue to change, with the US and Europe increasingly squeezed out of the equation. Asia’s progress reflects both political openness and the benefits of new technologies, without which capital could not swirl around the world in ever-increasing volumes. Is it too much to suggest that the ease with which capital can cross borders and time zones represents a revolution as great as that triggered by the pioneering explorers who discovered the New World and rounded the Cape of Good Hope, in the process undermining the Silk Road and the economic and political power of Islam? If so, does the rise of Asia in the 21st Century mirror the rise of Europe in the 16th Century and beyond?

And the Ugly
Can the Western powers manage to maintain control? Yes, but at a significant price. The developed world would have to disengage from the emerging world. The frameworks to do so already exist. The North American Free Trade Association and the European Union could quite easily become aggressive, inward-looking customs unions, maintaining openness for the privileged few while ignoring relations with the rest of the world. There is no shortage of supporters.


Trade protectionism is bad enough but there’s also the risk of capital market protectionism. Governments could enact legislation to ensure that savings were invested at home rather than abroad. As with Dubai Ports World, they could refuse to sell assets to ‘untrustworthy’ foreigners. The rise of state capitalism is an obvious trigger for a newly ‘national’ approach to the balance between savings and investment, thereby reducing the chances of allocating capital efficiently on a global basis. Another trigger is the 2007/8 credit crunch: if cross-border capital flows are deemed to have disruptive economic effects, either cyclically or because of the burden on future taxpayers, why not restrict banks merely to domestic financial activities, thereby reversing the massive opening of capital flows that has taken place since the 1980s?

Imagine the consequences. The West wouldn’t so easily be able to invest in the emerging world, which would lead to a reduction in returns on capital and, thus, lower savings for its pensioners. Resources wouldn’t be allocated so efficiently, which would reduce global output. Trade barriers would restrict cross-border specializations. The price of tradable goods would rise. American Treasury yields would spike higher as China and others disengaged from the world’s bond markets. Economic autarky would replace the freedoms we have grown accustomed to over the last thirty years. We’d head back to a world last seen in the first half of the twentieth century, when economic and political crises on the grandest of scales occurred with monotonous and frightening regularity.

In the midst of this protectionist endeavor, there would probably be a series of currency crises, offering a repeat of some of the conditions seen in the 1970s. With the US retreating from the world economy, the rest of the world would surely retreat from the US dollar. China would push harder to turn the renminbi into a new reserve currency, in the process accepting losses on its holdings of US Treasuries. Faced with a declining dollar, the US would suffer both an increase in import prices and much higher interest rates. Retreat from the global economy comes at a very high price.

The rise in economic nationalism would, in all likelihood, be linked to a descent into ethnic rivalry. With the developed world running out of workers, this would surely create conditions in which the time bomb of demographic ageing would go off with a particularly big bang.

And then there’s the possibility of war. As the emerging world becomes economically stronger, it will also become militarily more powerful. In the attempt to secure food and fuel supplies, will nations find themselves fighting each other for access to scarce resources?

What happens if the property rights surrounding investments by the developed world in the emerging nations prove to be inadequate? Investors in the developed world are expecting more youthful populations in the emerging world to work hard for them in their retirement: is this really an economic match made in heaven?

The history of the world is full of strategic miscalculations. There’s no reason to believe the future will be any different. The West can play its part in ensuring the smooth progression of globalization, but it can also throw the whole process into reverse.

Excerpted from Losing Control: The Emerging Threats to Western Prosperity, new from Yale University Press. Copyright © 2010 by Stephen D. King. Reprinted by permission.