CHAPTER 7

Doubling Down on Economic Statecraft: What’s at Stake for the United States and the World America Built?

Jennifer Harris¹

In early 2009, as the scale of the global financial crisis was only just becoming clear, U.S. secretary of state Hillary Clinton began to signal that economic considerations would play a much more central role in the decisions that guide U.S. foreign policy.² For some, this move was long overdue. As Les Gelb explained in a 2010 piece for Foreign Affairs, “Washington still principally thinks of its security in traditional military terms and responds to threats with military means. The main challenge for Washington, then, is to recompose its foreign policy with an economic theme, while countering threats in new and creative ways.”³

Clinton then unveiled the specifics behind this strategic shift in a series of four speeches, culminating in remarks before the Economic Club of New York in October 2011. Said Clinton:

Right now, the challenges of a changing world and the needs of the American people demand that our foreign policy community, as the late Steve Jobs put it, “think different.” Our problems have never respected dividing lines between global economics and international diplomacy. And neither can our solutions. That is why I have put what I call economic statecraft at the heart of our foreign policy agenda.⁴

Secretary Clinton’s vision of “economic statecraft” will remain a work in progress for some time to come, but looking ahead to the obvious geo-economic implications of so many looming challenges, it is clear that the stakes surrounding this process are rising quickly—both for the success of U.S. foreign policy and for the “world America built.”

How much progress has already been made and what can we expect for the next several years? There are three emerging geo-economic trends that will pose foundational questions for U.S. foreign policy makers over the next half decade. Together these trends suggest that the United States would do well to double down on economic statecraft in years to come.

ECONOMIC STATECRAFT: U.S. FOREIGN POLICY IN AN ERA OF ECONOMIC POWER

The State Department’s economic statecraft agenda follows from a simple premise: changes in the world’s economic and financial systems require corresponding changes in U.S. foreign policy. This is true in three major respects.

First, faced with emerging nations that wield primarily economic power, U.S. policy makers must update both their perception of U.S. interests and America’s diplomatic arsenal. We have entered an era in which governments are as likely to use state-led investment decisions, trade restrictions, and new limits on the export of critical commodities as military assets to achieve their diplomatic and security goals.

Second, with 70 percent of global growth now fueled by emerging economies, America’s economic revival will depend increasingly on an extension of trade ties, making foreign policy more directly essential for economic growth and job creation at home. Yet, faced with state-sanctioned theft of intellectual property in some countries, with state-owned and “national champion” competitors that enjoy subsidized financing, and with entire industries that remain off-limits to imports and investment, private firms (American or otherwise) may require diplomacy to level commercial playing fields and confront what are often state-led market distortions.

Finally, markets themselves shape diplomatic realities as never before. Consider the euro zone crisis, driven at least as much on trading floors as in European capitals, and its potential to undermine a European project that has shaped U.S. foreign policy decisions for more than sixty years. These geo-economic realities, if not entirely new, are newly important.

The economic statecraft agenda outlines four broad lines of action where progress has already been made. First, policy priorities are being updated. For the past decade, the architects of U.S. foreign policy have necessarily concentrated their attention and energies on places where America faced the greatest and most immediate dangers. In the decade ahead, they must focus on those places that provide the greatest opportunities. This is part of the premise behind the Obama administration’s “Pivot to Asia,” where—through efforts like the Trans-Pacific Partnership (TPP); U.S. engagement with fellow member economies of APEC; and strategic dialogues with China, India, and others—the United States is reestablishing itself not simply as a resident diplomatic and military power in Asia, but as a resident economic power as well.

An updated foreign policy also means rethinking priorities with close allies and security partners in Europe and Japan. Too often, the economic dimensions of these relationships have lagged behind the security concerns. The United States remains one of nine countries in the world that have not yet progressed beyond basic “most favored nation” trading status with the European Union. But the United States and European Union may be nearing a solution: in June 2012, the U.S.-E.U. High Level Working Group on Jobs and Growth reached a preliminary conclusion in favor of launching a comprehensive U.S.-E.U. economic agreement.

The update of foreign policy priorities extends not only to new regions but to new trends, such as the resurgence of state capitalism, the rise of a global middle class, and the advent of financial markets as leading development engines. Progress on these issues will move forward by fits and starts, particularly on complex problems like the commercial implications of competition with state-run companies. A new interagency study, initiated by Secretary Clinton and managed by the Policy Planning Staff, has begun to develop a more sophisticated understanding of state capitalism. Responses to other trends are already more fully developed. For example, mindful that growing middle-class populations in Sub-Saharan Africa create new opportunities for foreign direct investment, the administration has begun to explore the possibility of negotiating the United States’ first regional (rather than bilateral) investment treaty with the five member states of the East African Community.⁵

Second, U.S. officials have become much better at tapping market solutions to meet complex strategic challenges. Many of the issues traditionally characterized as first-order “security” objectives—from fostering reform and successful democratic transitions in the Middle East to helping ensure freedom of navigation in the South China Sea—hinge increasingly on important economic dimensions. This has guided U.S. responses to democratic transitions across the Middle East and North Africa, where the bulk of U.S. support is aimed at helping new governments lay the economic foundations for successful democracies through fiscal stabilization measures, targeting private sector expansion and skills training, and providing incentives for structural reforms. Similarly, the “New Silk Road” efforts in Afghanistan and Pakistan aim to build a web of economic and transportation links that will embed Afghanistan in the economies of South Asia as NATO draws down its presence.

Third, Washington is playing better offense by updating and enhancing its ability to compete overseas—namely, by moving beyond support for the big one-off deal toward an integrated trade, investment, and commercial diplomacy strategy. This approach is intended to respond to a world of both global supply chains and market access restrictions, of intellectual property theft and state-backed competition. U.S. policy makers have intensified their efforts to attract investment with programs like SelectUSA, which “seeks to highlight the many advantages the United States offers as a location for business and investment.” They have customized efforts at commercial diplomacy that equip U.S. firms to target not just established trade hubs such as Shanghai and São Paulo but the next wave of emerging cities within the world’s leading emerging markets. Another highlight has been the pursuit of a competitive neutrality agenda to ensure that state-owned enterprises do not receive unfair advantages over private firms, whether domestic or foreign. That is the reasoning behind the recent U.S. tabling of a chapter on state-owned enterprises within the TPP, the first of its kind in any U.S. trade agreement.

Fourth, the State Department is streamlining its operations to deliver on this agenda. Presented in December 2010, the first-ever Quadrennial Diplomacy and Development Review made a series of organizational changes to strengthen the department’s ability to promote economic statecraft. It consolidated several bureaus with a new undersecretary for economics, energy, and environment. It also established a new chief economist to advise the secretary on a range of issues at the nexus of international economics and foreign policy. Lastly, the department is broadly reviewing how it hires and trains civil servants and foreign service officers to ensure they can keep pace with increasingly sophisticated global markets.

THE CASE FOR ECONOMIC STATECRAFT: THREE TRENDS THAT WASHINGTON CANNOT IGNORE

There is no shortage of geo-economic trends that are developing more quickly than national governments can respond. The three I choose here—the demise of traditional trade policy, the incremental reform of global governance, and shifts in the global reserve currency system—share a certain fragmentation across multiple disciplines that typically do not interact well with one another. This problem calls to mind John Godfrey Saxe’s parable of the six blind men and the elephant, as each element of policy making remains too isolated from the others for a strategically comprehensive approach to a complex set of challenges.⁶ And the central challenge in each case reinforces the essential theme of the economic statecraft agenda: U.S. foreign policy must adapt to a world in which economic trends come with profound strategic and geopolitical consequences.

THE DEMISE OF TRADITIONAL TRADE POLICY

The first trend centers on changes in global trade policy. International law has largely eliminated tariff barriers to trade between major economies, but governments have now developed a host of market-distorting practices not regulated by existing rules. These include state manipulation of currency values, policies to promote “indigenous innovation,” the deliberate nonenforcement of laws protecting intellectual property, and the construction of abusive regulatory regimes. Growing public awareness, in the United States and elsewhere, of these new barriers has undermined domestic public support for a robust, liberal trade and investment agenda, creating potential long-term problems for U.S. participation in further global economic integration. Much as the General Agreement on Tariffs and Trade (GATT) and the World Trade Organization offered a global solution to the problem of tariff barriers, Washington must develop a means of confronting the latest strains of protectionism that U.S. companies now face. In short, U.S. policy makers must create new rules and enforce them.

They must move beyond the current “trade and investment” framework toward an expanded approach centered on competition policy, by introducing dimensions of international antitrust law, currency practices, regulatory policy (including financial regulation as well as regulatory issues touching data and spectrum management), and mercantilist tax policies (such as value-added tax rebates for exporters). The single largest factor in the offshoring of U.S.-based production and millions of U.S. jobs, say many economists, is the packages of financial incentives that China and others offer global companies to encourage them to relocate production.⁷ China’s value-added tax rebates for exporters, for example, cost China the equivalent of 20 percent of annual government spending in 2010. Existing trade and investment rules simply do not address these realities.

Antiquated and inadequate rules are part of the problem, but enforcement is crucial. In a world of competing global supply chains and integrated capital flows, trade rules that focus largely on tariffs, national treatment, and “most favored nation” status are outdated. The harmful practices tend to be fluid, and where one is struck down or becomes too controversial, governments can easily reintroduce it with a slight refinement. For example, as quickly as rules are created to govern state-owned enterprises, governments can reroute subsidies to redefine what “state-owned” means. Compounding the problem, many of these practices are inherently difficult to link to specific injuries suffered by individual U.S. companies. Put simply, the most salient market barriers today do not lend themselves to inventorying the universe of particular unfair and distortionary practices and then applying disciplines to regulate or prohibit them. Rather, U.S. firms need rules that quantify the harm done by governmental market distortions and impose remedies based on that measure, rather than the specific act that caused the harm.

The fundamental premise of existing U.S. trade architecture is that all participants subscribe to the same basic tenets of liberal, neoclassical, free trade based on comparative advantage. But faced with mounting distortions, many Americans question not simply whether countries are playing by the same rules, but, to quote economist Clyde Prestowitz, “whether countries are even playing the same game.”⁸ The United States has an overwhelming strategic interest in answering with a new vision for leveling global playing fields—one that repairs the viability of the market-based assumptions that have anchored the post–World War II trading system and responds to each new form of “modern mercantilism.”

THE SLOW BOIL OF GLOBAL GOVERNANCE REFORM

The reform of global governance is moving forward—though only by fits and starts and often more as a form of emergency response to emerging crises than as carefully calibrated steps in a well-coordinated multilateral strategy. Tectonic shifts in capital markets over the past decade—and the many domestically focused policy responses to them—demonstrate this best. Yet, the decision to shift the emphasis in international policy making from the Group of Eight (G8) to a Group of Twenty (G20) and changes to the institutional mechanics of the International Monetary Fund merely reflect shifts of scale and geography. The magnitude of the Asian financial crisis was in the tens of billions; today’s euro zone crisis is in the trillions. Until fifteen years ago, Washington had unmatchable influence in determining where capital originates, how it is intermediated, and where it ends up, but this control has eroded on all three scores.⁹ These underlying changes did help to prompt calls for global governance reform, but it was not until artificially cheap money from a handful of countries, particularly China and Japan, met with deregulation in the United States that the “premier forum for international economic and financial issues” grew from eight nations to twenty.

Some might argue that this is the way global governance should evolve—as an intermittent Darwinian adaptation to changes in the international environment rather than as the product of strategic coordination among officials in a single country or bloc of powerful countries. Compare the hapless choreography of the never-ending Doha trade round with the ultimately effective improvisations of the G20, an organization that has performed best when tested most.

From an American perspective, this hands-off approach fails in at least three respects. First, it does nothing to confront problems of free riding. America has underwritten the growth of the emerging markets through its security guarantee and its defense of a liberal economic order that creates opportunities for dozens of countries at once. Many Americans have begun to question the fairness of this system and are increasingly reluctant to pay to buttress it; this in turn leaves more room for free riding, instigating a vicious cycle with unknown risks.

Second, new problems demand creative solutions. Take technology-driven issues like cyberespionage and data privacy, for example. In both cases, the United States has much more to lose from cyberattacks, particularly those that represent commercial espionage and sabotage, than do emerging markets. Yet neither the U.S. government nor existing international institutions are well organized to address the blend of state and nonstate actors, and the prevalence of U.S. private-sector targets, inherent in the cybersecurity and espionage challenges.

Finally, a hands-off approach to global governance forfeits the crucial opportunity to use the prospect of global governance reform to incentivize the emerging powers to undertake the difficult domestic reforms that even they acknowledge are in their fundamental interest. These institutions were designed to create a gravitational pull that compelled countries along a steady reform path—ensuring, for example, that given enough time, economic growth, and intermingling of capital flows, global markets would change China, Russia, and the monarchies of the Persian Gulf more than these countries would change global markets.¹⁰ State investors would become private investors, and illiberal regimes would become liberal ones. This view of market transitions, however, requires the gravitational pull of a far healthier set of global institutions than the world at present seems equipped to provide.

GLOBAL RESERVE CURRENCIES AND GREEN SHOOTS OF FINANCIAL REFORM IN CHINA

A third geo-economic trend posing a challenge for the U.S. centers on potential changes to the makeup of the world’s reserve currencies—from the fate of the euro to the rise of China’s renminbi (RMB)—as well as related questions stemming from green shoots of financial reform inside China. If present trends continue, the next decade could see the largest alterations of the world’s monetary architecture since 1945. Of perhaps equal importance, China stands on the verge of its most important changes since the reforms of Deng Xiaoping began in the late 1970s. In both cases, Washington will have to adapt.

China is beginning to back its stated goal of rebalancing the RMB and positioning it as a reserve currency with real action. Chinese purchases of U.S. Treasuries have declined in recent years, and the RMB has significantly appreciated. Wages are rising, and Chinese trade surpluses have fallen back below 2 percent of GDP. Yet, for all of these positive indicators, there is evidence of less progress in the real economy. Consumption as a share of GDP remains at roughly 35 percent, by far the lowest of any major economy. By comparison, U.S. consumption is roughly 70 percent of GDP.

But in the financial realm, Beijing is having more success in translating effort into positive results. In 2009, China began steadily expanding the percentage of the country’s trade that could be settled in RMB. By February 2012, this applied to all trade, and RMB-denominated trade had come to account for roughly 10 percent of total Chinese imports and exports. In 2010, Beijing dramatically enhanced Hong Kong’s ability to conduct offshore RMB transactions, thus giving quick rise to a now global market in “dim sum bonds.” Thus far in 2012, China has only hastened the pace of its financial liberalization measures—widening the trading band on the RMB, allowing greater capital inflows, permitting a domestic pension fund to invest in the stock market, and, not least, outlining a detailed, three-part proposal for loosening the country’s capital controls (released by the People’s Bank of China in February 2012).

These measures will create a greater international role for the RMB. Many experts argue that this change cannot come too soon. Today’s world, say economists like Fred Bergsten, is one where emerging markets are growing faster than the United States and deepening their financial markets in ways that demand central bank holdings far above those the United States alone can provide.¹¹ Were the RMB to become a reserve currency, China could serve as a provider of this insurance, not just a demander. Further, launching the RMB as a reserve currency would require China to liberalize its financial sector and undergo a slew of reforms that are fundamentally in the United States’ interest.

Still, the prospect of the renminbi joining ranks as a global reserve currency raises a number of considerations. There are advantages to reserve currency status, and U.S. policy makers must determine if the United States can keep its share of these advantages while accommodating the emergence of the RMB. After more than sixty years, many Americans have come to take such exorbitant privileges for granted. In today’s financial world, we cannot yet say if maintaining these privileges is an all-or-nothing proposition, but we can say that losing them would force U.S. policy makers to confront new trade-offs between foreign policy objectives and the higher domestic costs required to support them.

CONCLUSION

In the words of one top-ranking military official, the current economic statecraft agenda and its major lines of work “successfully paint the mountain”; the next major task is “translating this into a new vision to organize our foreign and economic policy.” Much as, in the years after 1945, all U.S. officials understood that all of their efforts—whether military, economic, or diplomatic—were to advance a liberal economic order, U.S. foreign policy will need a new organizing vision to replace the fraying post–Bretton Woods consensus. This vision needs to articulate why and in what ways our values and interests have changed as a result of the changes to the global economic landscape of the past ten years. And if current trends hold, a new guiding principle will be needed sooner rather than later.