It is undeniable that the postwar liberal international rules-based order, a political creature that the US primarily contributed to shaping by fostering global, multilateral and democratic institution-building processes, has come under severe pressure by contrasting forces. The fall of the Berlin Wall and the disintegration of the Soviet empire determined the advent of a unipolar New World Order – as emphatically proclaimed by President George W. Bush, in 1991 –, where the United States was the only global superpower. In short, the “End of History” as gloriously celebrated by Stanford‘spolitical scientist Francis Fukuyama in his best-selling book. Furthermore, the American foreign policy official doctrineconceptualized the theory of Pax Americana, whereby the US essentially self-imposed on its immense military and eco-nomic power a definite moral obligation to intervene in global theaters in order to defend and advance liberal-democraticvalues and economic prosperity.
Thanks to this unique and undisputed legitimacy, America could dominate the community of nations by the primary use of its vast soft-power (though hard military power was never realistically entirely written off by White House stra- tegists), its incontrovertible credibility and world leadership. The Westphalian model of great-power relationships and the balance-of-power geostrategic approach which characterized the system of international relations since the 17th century was inherently transformed by the ascent of the American supremacy. The Harvard’s historian Graham Allison in a recent Foreign Affairs essay quoted the political scientist and foreign policy expert Joseph Nye as declaring: “The demonstrable success of the [international liberal rules-based] order in helping secure and stabilize the world over the past seven decades has led to a strong consensus that defending, deepening, and extending this system has been and continues to be the central task of U.S. foreign policy.”
Global supply-chain and financial integration, which in turn should theoretically translate into constant GDP growthand a general increase in social welfare, is in Nye’s opinion of paramount importance in upholding free liberal-demo- cratic political institutions. He went on by asserting: ”I am not worried by the rise of China. I am more worried about the rise of Trump”.
Contrary to Nye’s belief, Princeton’s Stephen Kotkin wrote: “Too many convinced themselves that global integration was fundamentally about economics and sameness, and would roll forward inexorably”. Kotkin essentially bases his work on Samuel Huntington’s Clash of Civilization theory, whereby the latter consciously predicted that cultural fac- tors would eventually prevail over economic integration forces, accentuating national differences and tribal identities. Even Stanford’s Francis Fukuyama went back drawing on Huntington’s monumental work and is currently writing on a new book entitled Identity Politics. By the same token, Giulio Tremonti, the former Italian Minister of Economy and Finances and a jurist, in his latest book Mundus Furiosus (a Sixteenth-century Latin expression for an age of tumults and agitation, discord and subversion) is constructively critical upon the evolution of globalization, and suggests byelegantly drawing on historical analogies a new set of radical reforms for the financial system.
The Decline of the American Supremacy: A New Balance-of-Power
It follows that the general academic, as well as policymakers’ consensus, views the 2007 Great Recession as theinflection point of American global dominance. The Credit Crunch exposed the inherent weaknesses of an overly fi-nancialized economic structure, where private debt overhangs are still unimaginably high vis-à-vis current GDP levels, thereby limiting sustained potential output and employment expansion. When significant growth is achieved – as theformer Treasury Secretary, Harvard’s Lawrence Summers, wrote in his remarkable The Age of Secular Stagnation – it is because of unsustainable borrowing levels and monetary overexpansion, which ultimately translate into egregious asset prices distortions, resources misallocation, and unsustainable levels un unproductive investments (as it was in the case of the US and southern-European housing bubbles).
Furthermore, the broad majority of American strategists, which includes many of Mr. Trump Administration’s top policymakers and West Wing National security advisors (notably John Bolton and Peter Navarro, and to a less extent the current Secretary of State and former CIA director, Mike Pompeo) view the challenge of the intense technological com- petition rising from China and its authoritarian style of state-driven capitalism as the greatest threat to the US nationalself-interest. Indeed, the recently published National Security Strategy clearly defines the contest for global power asa “central continuity in history”, and depicts the major “revisionist” powers active in the economic and military arena, namely China and Russia, in worryingly antithetical terms vis-à-vis the core of longstanding western-American values: “Three main sets of challengers: the revisionist powers of China and Russia, the rogue states of Iran and North Korea, and transnational threat organizations, particularly jihadist terrorist groups, are actively competing against the UnitedStates and our allies and partners”. More specifically: “ China and Russia want to shape a world antithetical to U.S. values and interests. China seeks to displace the United States in the Indo-Pacific region, expand the reaches of its sta- te-driven economic model, and reorder the region in its favor. Russia seeks to restore its great power status and establishspheres of influence near its borders”.
At any rate, Blackstone’s’ Byron Wien in a recent blog post argues against the profound fallacy of interpreting Chi-na purely as an extremely efficient manufacturer “through a combination of the creative use of robotics and low laborcosts”, while by the same theory asserting that its government’s undemocratic institutions would essentially prevent thevital free flow of ideas thus stifling innovation. That is no longer true. Mr. Wien rightly holds that “we all know that on a Gross Domestic Product basis, China is the second largest economy in the world and, if it continues on its presenttrajectory, it will become the largest economy sometime in the 2030s. This is inevitable to the extent China grows at a real rate of better than 5% while the United States grows at only 2%–3%. On a Purchasing Power Parity basis, China isprobably the largest economy in the world now. When China joined the World Trade Organization in 2001, its GDP was only 13% of the U.S. GDP, according to Niall Ferguson. By 2016, it was 60% and by 2023 the International MonetaryFund projects it will be 88%”.
Even more importantly, recent China’s advancement in biomedical technology is simply astonishing. According toa recent Goldman Sachs report quoted by Mr. Wien: “ In 2016, the government launched a 15-year project, the ChinaPrecision Medicine initiative, with a $9.2 billion budget. The effort has focused on early cancer diagnosis and, more recently, gene editing, gene therapy, and cell therapy. China’s program is similar to the United States’ program in inten- sity and ahead of those in Europe and Japan”. Also, “[despite] the area of gene editing is controversial, and Europe and the United States have taken a cautious approach. China has become the leader here with nine clinical studies of cancer and HIV infections versus only one in the U.S. The studies were at top-tier hospitals and were government-sponsored”.
Finally, it is worth remembering that China leading technology firms Baidu, Alibaba and Tencent Holdings are po- sting extraordinary growth rates, certainly parallel to those of their American counterparts. The Chinese governmentclaims it requires a holding of a 1% stake in some the most highly profitable technology firm in order to improve pro- ductivity, which according to Mr. Wien constitutes a way of exerting a sort of control over the evolution of critical tech- nology ecosystems. General educational levels have also been substantially improved, with “Chinese students studyingscience and technology increasing from 359,000 in 2000 to 1.65 million in 2014. In the U.S. the corresponding increase is from 482,000 to 742,000”.
It is, therefore, no surprise that in view of its millenary history and the last two decades of extraordinary relative economic outperformance vis-à-vis the West, China is now trying to impose its own legitimacy by piecemeal designing new regional orders based on its own generally accepted principles of power equilibrium and stability. In a famous 1957 book, A World Restored, Henry A. Kissinger wrote: “The characteristic of a stable order is its spontaneity; the essence of a revolutionary situation is its self-consciousness. Principles of obligation in a period of legitimacy are taken so much for granted that they are never talked about”. On the other hand, In revolutionary situations: ”Principles are so central that they are constantly talked about”. A vague resemblance to Trump’s America First global policy.
Not for nothing Chinese policymakers – as well as the Russians and Indians – regard the inherent fragility of our po-litical and financial systems, as it has been dramatically exposed by the Great Recession, as fundamentally undesirable:therefore they are ready to challenge the status quo, by pushing their principles to the ultimate conclusion. On the other hand, China – contrary to the US – could not afford a trade-induced recession, as it will dangerously test its internal social stability. Consequently, we do expect that diplomacy and high-level institutional engagement will regain a central stage in the coming months and that the existing structure of international relations will be – at least for the present – preserved in favor of the United States.
Nevertheless, the considerable decline in the perceived US credibility and the deep sense of frustration and insecurity sowed in America’s strategic allies by what is judged as an irrational and fundamentally hostile conduct will not be cost- free. As Mohamed El-Erian, chief economic adviser at Allianz, and former chairman of US President Barack Obama’sGlobal Development Council recently wrote on Project Syndicate: “G7 members lost a valuable opportunity to develop common positions on issues about which they could agree, and the rest of the world was shown more evidence that the global system’s long-standing core-periphery relations are no longer reliably buttressed by unity among established eco-nomic and financial powers. At a time of considerable political and social fluidity, destabilizing the remaining anchorsrepresents a risk to the system as a whole”.
Towards a New Economic Paradigm: Central Banking after the Great Recession
So, we now ought to take up the question of where do we detect today’s most potentially destabilizing risk-factorsfor the global economy. For one thing, and with the benefit of the hindsight, unconventional monetary policymaking response to the Great Recession and – specifically in the US – the mechanisms of countercyclical fiscal stabilization,while proving effective in preventing a further catastrophic loss of output and employment, substantially failed – inthe tenth year since the Recovery started – to fuel a return to levels of inflation considered to be normal or satisfactory by historical standards. The current widespread framework of Central bank independence based on inflation-targetingis the result of a broad set of convictions held by the so-called “new-Keynesian” scholars concerning the fundamentalinadequacy of monetary policy in order to influence the average level of output and employment over time. Harvard’s Lawrence Summers in a recent Brookings paper urges the Federal Reserve to re-think not only the arbitrary 2% infla-tion target, but more broadly the overall current monetary policy framework by highlighting the potential beneficial effects of explicitly indicating a nominal GDP target level of 5 to 6 percent. In essence, the current probability ofthe economy experiencing a recession is approximately between 15-20 percent per year. Considering that historical observation tells us that the average short-term interest rate cut necessary to combat an economic downturn is of 500 basis points and that realistically the current US real growth rate is “more 2 percent than 3.5 percent“; with nominal interest rates constrained at the zero-lower-bound, Central banks (even more critically the ECB) have very little room to respond to future recessions.
In addition, in the absence of robust evidence concerning the effectiveness of the quantitative easing, the set of unconventional monetary policy instruments which would technically overcome ZLB constraints is factually limited. With the current 10-year Treasuries yield to maturity at 2.9 percent, one can reasonably expect that conventional short-term interest rates cuts would realistically bring long-term rates down to 1.5 percent. At that point, Summers argues, it is highly questionable what extra monetary stimulus could be delivered, if not only marginal. So we’re es- sentially running the risk of stumbling into the next downturn without having the right monetary framework in place.More specifically, there are reasons to believe that macroeconomic policymakers on both sides of the Atlantic are failing to balance the implicit trade-off between the perceived costs associated with temporary running actual inflationlevels above the 2% target, with concrete and potentially cataclysmic loss of potential output and employment linked with prolonged recessions.
Similarly, we question the rationale behind the current statutory ECB’s primary narrow price stability mandate. Indeed, as Morgan Stanley’s Reza Moghadam recently wrote on the Financial Times, pragmatists within the Gover-ning Council led by the President, Mario Draghi, faced stiff resistance when formulating and approving the OutrightMonetary Transactions program, and eventually “ [the OMT, as well as the PSPP] was sold as safeguarding the mo-netary transmission mechanism”. So, since in a complex monetary union with narrow national governments’ fiscal space the ECB still realistically constitutes the “only game in town”, financial stability (through macroprudentialpolicies), as well as growth and employment objectives, should plausibly be given equal importance. Therefore, calling for a dual-mandate framework in essence similar to the Federal Reserve’s primary objectives of price stabi- lity and maximum employment. That is even truer since we have been observing profound shifts within the Phillipscurve relationship between unemployment and inflation: as “it now takes a larger increase [in the former] to engineer a decline in inflation. Moreover, the damage inflicted by recessions is longer lasting”. Likewise, former Federal Re-serve Chairman, Ben Bernake, notably wrote in the latest PIMCO Global Economic Outlook that there is sufficient evidence to believe the Phillips Curve is now flat, meaning that “low unemployment won’t necessarily translate into an acceleration in inflation. Moreover, the Fed appears willing to accept a modest overshoot of its inflation target”.
The European Existential Crisis: Policy Divergence and Genetically Modified Techno-Populism
The case of Europe – and specifically Italy – over the secular horizon remains more controversial. Thus far, we’veseen increasing policy divergence vis-à-vis the United States, as the latter is on a path of an aggressive expansionaryfiscal stimulus program, which would plausibly provide business confidence with significant impulses. However, the projected increase in fiscal deficit and, reasonably, a growing debt-to-GDP ratio would almost certainly compress US fiscal space over the long term, leaving the Federal Reserve with its policy tools facing the next recession. Moreover,there are valid arguments to believe we’re at the outset of a “secular bear market for bonds” as Blackstone’s strategistJoe Zidle asserts. Although we do share the thesis that there is sufficient evidence that Treasury yields will follow an incremental path, we do remain somewhat skeptical over the intensity of inflationary pressures over the long-term (at least by observing what the market implies by the current long-term Treasury inflation-protected yields), and believe they will remain structurally lower than during the previous 1940-1982 cycle.
To be sure, inherent financial markets fragility will remain the central issue over the secular horizon, in particu-lar for Europe, posing the highest risk for global investors. For one thing, the structure characterizing our financialecosystem has profoundly changed since the Great Recession. The rise of high-frequency-trading and short-volatilitystrategies constitute, in Goldman’s Charlie Himmelberg’s view, a significant factor of market vulnerability. Indeed, the recent sell-off caused by negative idiosyncratic political news-flow from Italy could have been reasonably exa- cerbated by a substantial lack-of-liquidity effect rather than an abrupt change over the Country’s debt sustainability dynamic. Furthermore, the post-QE world the Central banks have incidentally shaped, with massive “wealth-effect” rewarding the most liquid fraction of the population, has fallen short of producing the expected systemic deleveraging by fueling monstrous dislocations¬ – notably affecting the high-yield bond market.
So, while George Soros‘ opinion that the EU is undergoing an “existential crisis” is in principle adequately re-asonable, we must note that “genetically modified” techno-populism governments – in particular in Italy – couldpotentially succeed in urging more radical EU reforms. Indeed, the increasingly confrontational posture characte- rizing the Italian Minister of the Interior, Matteo Salvini, could optimistically contribute to policy changes towards a more pronounced EU collective risk-sharing approach over the refugee crisis. Also, the Minister of the Economyand Finances, Giovanni Tria has publicly committed to fiscal discipline by maintaining his predecessor’s moderately expansive fiscal stance.
In other words, we conclude that political volatility will still be the dominant factor determining the European dynamics. More importantly, while we highlight that some sort of political consensus upon the completion of the Ban- king and Capital Market Unions is gradually emerging in the Franco-German agenda, it remains highly questionable whether they could plausibly constitute effective structural changes rather than gentle concessions.