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Foreign Economic Policy for the Next President

by C. Fred Bergsten, Peterson Institute for International Economics

Essay in Foreign Affairs
March-April 2004

© Institute for International Economics.


The Dangers of Rollback

At a time when U.S. foreign policy is dominated by war, terrorism, and weapons of mass destruction, economic concerns are often relegated to the back burner. But in reality, economic policy must be an integral component of any successful foreign policy. Some of its elements, such as the suppression of terrorist financing and support for reconstruction efforts in Iraq and Afghanistan, bear directly on the most central national security concerns. The linkage, however, is much broader, because most countries, rich or poor, large or small, depend heavily on the global economy for their prosperity and their stability. Hence, economics ranks at the top of their list of concerns. To continue to be relevant to the rest of the world, the United States must engage effectively on these issues.

As the sole military superpower, the United States may often be able to undertake unilateral initiatives for the sake of national security. But in economic policy, unilateralism is simply not an option. No government, Washington included, can ignore market forces. The European Union's economy is now as large as that of the United States, and the euro has begun to challenge the dollar for global financial leadership. The United States relies on foreign investors—including the monetary authorities of competitor Asian economies—to finance massive external deficits, and it depends on oil imported at prices set by producers in other countries. Cooperation is therefore a necessity in the realm of international economics. Indeed, because of the close connection between economics and other international issues, economic policy often restrains the unilateralist tendencies in U.S. foreign policy as a whole.

Foreign economic policy is also critical to the health of the domestic economy. Over the past generation, the share of trade in U.S. GDP has tripled, to about 30 percent, and over the past decade, the competitive stimulus provided by rapid globalization has helped spur a dramatic increase in productivity, thus contributing to faster growth and job creation as well. On the financial side, foreigners' willingness to invest more than $500 billion a year in the United States funds massive trade deficits and makes up for low domestic savings rates. Overall, the reduction of trade barriers over the past 50 years has raised the annual income of the average family by $2,000.

But for the past decade, U.S. foreign economic policy has been mired in stalemate. For eight years, Congress refused to authorize the president to negotiate new trade agreements. When it finally did so in 2002, it was thanks only to a series of protectionist concessions on the part of the Bush administration. Legislation to replenish the International Monetary Fund (IMF), meanwhile, languished for more than a year at the height of the Asian financial crisis. It was rescued only by the intervention of a farm bloc seeking new funding for sales to major overseas markets.

The main reason for this stalemate is that global economic developments have harmed many individuals in the United States even as they have benefited the economy as a whole. Changes driven by technological advance and globalization have disrupted firms, communities, and workers, and a small but significant number of workers—perhaps 150,000 a year—suffer dislocations and significant earnings losses due to trade. Many others fear that "there but for the grace of God go I." It is now becoming clear that white-collar jobs can be "outsourced" just as blue-collar jobs have been.

U.S. policymakers must decisively overcome the domestic backlash against globalization to create a firm political foundation for a sustainable and constructive foreign economic policy. But the outlook is worrisome, despite the current economic recovery. Overvalued exchange rates and the massive trade deficits they create—characteristics of the current U.S. economy—have historically caused a retreat from openness. The admirable efforts of the Bush administration to revive liberalization have mostly run aground: the Doha Round of World Trade Organization (WTO) negotiations stalled at Cancún in September 2003; the Free Trade Area of the Americas fared similarly poorly at Miami in November 2003; and bilateral free trade agreements are facing stiff congressional resistance and may have to be shelved. Moreover, disputes between Europe and the United States could spark a transatlantic trade war, and a vicious round of China-bashing has erupted over the past year. These developments have put U.S. trade policy, and hence the global trading system, in deep jeopardy and could start to reverse the profound benefits of globalization.

Stopping the advance of globalization would be very dangerous to U.S. foreign policy because globalization—more than terrorism or the end of the Cold War—has been the dominant force for change in international affairs in the past 50 years. And rightly or wrongly, it is equated with Americanization in much of the world. Debates over globalization are often debates over the role of the United States itself. A significant rollback of globalization, or a halt in its continued advance, would therefore represent a major defeat for the United States on the world stage. The next administration must recognize the urgency of the situation and make foreign economic policy a top priority.

 

A New Global Order

More and more, "emerging market economies"—China and India, most notably—are becoming world-class competitors in a range of sectors. This development will require even more rapid improvement in the skills of U.S. workers and the flexibility of U.S.-based companies. It will require more effective safety nets to cushion the inevitable victims of transition. It will necessitate continuing U.S. policy reforms to increase the country's competitiveness and diligent negotiations on trade and other international issues to assure a level playing field.

But new competitors also offer attractive markets for U.S. exports and investment. They are valuable suppliers of high-quality, low-cost goods. And if properly incorporated into the global economy—and paired with effective domestic policies in the United States—they will lead to new gains in global growth, as well as improvements in U.S. productivity that will further magnify the benefits of globalization for the United States.

The most difficult challenge facing the next administration stems instead from fundamental changes in the structure of the global economy. Since World War II, the United States has been able to dominate the world economy, even during periods of poor performance and dreadful policy, because it has been the only economic superpower. (U.S. military supremacy may have helped on occasion, but there is, in reality, little day-to-day spillover from security to economic affairs.) Japan has never played a major role in global economic policy, and Europe, even after the creation of the EU, has failed to consolidate its decision-making and speak with a single voice. The notable, and highly instructive, exception has been trade policy: Europe did centralize its policy and so forced Washington to deal with it as an equal.

All of this is now changing rapidly. When it expands to 25 members this year, the EU will have a total output (not to mention a population) greater than that of the United States; it is already the world's largest trading entity, and the euro has become a key currency along with the dollar. Europe has not yet consolidated its decision-making or external representation, but it is sure to do so over time.

Even more dramatic changes could come across the Pacific. China is likely to continue growing rapidly for at least two more decades, becoming an economic superpower in its own right. In addition, East Asia is in the process of creating an economic bloc that could eventually comprise both a regional free trade area and an Asian monetary fund. Such a bloc would claim about one-fifth of the world economy, 20 percent of global trade, and $1.5 trillion in monetary (mostly dollar) reserves—about ten times those of the United States. Such an East Asian group would be a third economic superpower.

This confluence of events could convert the unipolar economic order of the past half-century into a bipolar or tripolar one, forcing Washington to navigate in very unfamiliar waters. U.S. foreign economic policy will have to overcome the challenges of integrating emerging powers into existing global structures and of managing the world economy by committee. It will have to forge new techniques of cooperation among near-equals, as well as compete in increasingly fierce global markets. It will have to draw on its strong ties with both Europe and Asia (which are far stronger than links between the two) to promote its own interests and secure the place of the United States as the pivotal actor in shaping new multilateral regimes.

A reelected President Bush or his successor will have to design and implement new initiatives to address global economic challenges of the highest national and international priority: forging a new domestic consensus in support of globalization; restoring and maintaining a sustainable external financial position; reviving trade liberalization; and freeing the world economy from the manipulation of energy markets by leading producers. He will have to do all of this in a new global economic context, in which a unified Europe, a rising China, and a new Asian bloc are shattering the final vestiges of U.S. economic hegemony.

 

Credit Check

The United States is by far the world's largest deficit and debtor nation. Both the U.S. economy and U.S. foreign policy are thus put at serious risk by the prospect of an outbreak of trade protectionism, foreign unwillingness to finance the $4 billion needed every working day to balance U.S. books, or even dumping of large portions of the $10 trillion in U.S. currency held abroad (driving interest rates up and the U.S. economy down). The continued buildup of debt owed to foreigners, moreover, will steadily erode national income over time. The next administration must work to restore a sustainable current account and international financial position.

The goal should be to cut the external deficit in half, from its present level of $550 billion (or more than 5 percent of GDP). This reduction would have the important effect of stabilizing the ratio of foreign debt (already more than $3 trillion) to GDP. The only lasting way to do so is to sharply increase the savings rate in the U.S. economy, so that massive foreign capital inflows no longer push the dollar to overvalued levels and generate huge trade deficits. There is, unfortunately, no proven policy to increase private saving. Hence the government must convert its own budget deficit into a modest surplus, at least in periods of robust growth as at present.

Unfortunately, budget correction will not likely come soon enough to reduce the vulnerability created by external deficits. More immediate, if less fundamental, remedies are also required. The only feasible option is reducing the value of the dollar by 25 percent from its early 2002 peak. That decline has already begun, in a gradual and orderly manner, and it is probable that markets will also generate the rest of the correction. Because the U.S. economy is performing well relative to other large economies, there is little risk of a "hard landing." U.S. policymakers should thus make sure that market forces are allowed to prevail in lowering the dollar's value, threatening direct intervention if necessary to offset intervention by other countries (especially China and Japan) seeking to block the adjustment.

The problem of U.S. external deficits has been a recurring one over the past 30 years. Therefore, in addition to restoring sustainable trade and current account balances now, U.S. policymakers must recognize the need to revamp the institutional arrangements that govern exchange rates and overall economic relationships between countries. For all the talk of "reforming the international financial architecture" over the past decade, little has been done. The Treasury Department under both Presidents Bill Clinton and Bush—and the group of seven highly industrialized countries (G-7) and the IMF as well—have allowed countries such as China and Japan to violate existing rules while ignoring the need for basic improvements in such rules.

The next administration should negotiate fundamental improvements in the international monetary system, in order both to protect the United States against a return to unsustainable deficit levels and to provide a more stable foundation for the global economy as a whole. The most promising approach would be to implement new mechanisms limiting the deviation of exchange rates from their equilibrium values through close cooperation between economic policymakers in major countries.

 

New Paths to Open Markets

Trade liberalization, an integral aspect of globalization over the past half-century, has dramatically helped the U.S. economy and contributed mightily to Washington's global leadership position. Further efforts in this direction will bring further benefits. Foreign economic policy must therefore remain devoted to the goals pursued by every U.S. administration in the past 70 years: reducing barriers at home and abroad to international exchange, and developing a rules-based trading system built around strong international institutions.

The United States has a strong interest in further opening international markets, moving as close as possible to global free trade, and strengthening the enforcement machinery of the WTO. Its comparative advantage in services and agriculture means that wholesale liberalization of those sectors, through aggressive U.S.-sponsored initiatives, would bring significant benefits. U.S. markets are already quite open, whereas other countries—particularly rapidly growing developing economies—maintain much higher barriers that can be reduced only through new international negotiations. Policymakers should work to eliminate the discrimination inherent in preferential trade deals engineered by Europe and, prospectively, by Asia.

In its first two years, the Bush administration achieved two notable successes in trade policy: the passage of fast-track negotiating authority and the launch of the Doha Round of WTO negotiations. Overall, it has pursued a coherent strategy of "competitive liberalization" in which multilateral, regional, and bilateral agreements reinforce and catalyze one another. These efforts, however, have recently run aground, and potential conflicts with Europe and China darken the picture even more.

The next administration must therefore attach high priority to reviving an effective trade policy. Most urgent is a more forthcoming offer of liberalization by the United States itself, especially in agriculture, to revive the Doha Round that broke down in Cancún. Washington must reverse the subsidy increases of the 2002 farm bill—contingent, of course, on fully reciprocal liberalization by other developed economies (chiefly the EU, Japan, and South Korea) and partial liberalization by the more advanced developing countries (chiefly Brazil and India). The United States should also repeat its offer to eliminate, again on a reciprocal basis, all duties on nonagricultural trade. The breakdown at Cancún proved that developing countries, united in a new G-22, can block multilateral trade progress on their own. Policymakers must recognize this fact and work constructively with the coalition, rather than trying to ignore or dismantle it. A successful Doha Round would then provide a firm foundation for a new "WTO plus" agreement in the western hemisphere.

The next administration must also revise trade policy as it relates to bilateral agreements. The list of bilateral partners chosen to date by the Bush administration (including Australia, Bahrain, Bolivia, Central America, Colombia, Ecuador, Morocco, Peru, the Southern African Customs Union, and Thailand, in addition to existing agreements with Canada, Chile, Israel, Jordan, Mexico, and Singapore) is arbitrary, offering modest benefits and little impetus to "competitive liberalization." Because of their limited benefits, these initiatives attract little support in Congress or the U.S. business community. Some of them have in fact attracted opposition sufficient to make their passage through Congress unlikely (at least in election year 2004). The Bush administration made the same mistake in selecting free trade partners that the Clinton administration made in pursuing fast-track negotiating authority in 1997: attempting to minimize domestic opposition instead of maximizing domestic support.

The next administration should, in close consultation with Congress, spell out four clear criteria for choosing free trade partners, in the following order of priority: net economic gains to the United States, promotion of constructive economic reforms in the partner country, importance for broader U.S. trade policy, and significance for overall U.S. foreign policy objectives. A few of the current candidates for agreements pass this test, but several others not on the list should be top priorities: Brazil (especially if the Free Trade Area of the Americas fails to move forward), South Korea, and, pending necessary internal reforms, Egypt and Indonesia. Washington should also offer a regional free trade agreement to Africa, as it has to Latin America, the Middle East, and Southeast Asia.

A revitalization of the Asia-Pacific Economic Cooperation forum (APEC) should also be part of the U.S. response to any European stalling and to the prospect of a new East Asian bloc. Just as President George H.W. Bush insisted on full U.S. participation when APEC was created in 1989 and President Clinton used APEC to pressure Europe to complete the Uruguay round, the United States should use strengthened transpacific ties as a counterweight to such developments. APEC can once again promote major U.S. foreign policy and economic objectives.

 

Domestic Backlash

The biggest barrier to a constructive and consistent policy on trade and globalization is domestic. The U.S. public is split virtually down the middle on these issues. Congress' rejection of fast track in 1994, 1997, and 1998, and its near-rejection of it in 2002, was an accurate reflection of divided public opinion, not an aberration by deviant legislators.

The country divides along educational lines. Workers with college degrees, or at least some college experience, support globalization because they think they can take advantage of the opportunities it offers. Workers who have not gone beyond high school—half of the U.S. labor force—oppose further globalization because they fear they cannot adjust to it. The only long-term strategy for achieving domestic consensus, therefore, is to improve education and raise the overall skill level of the population. In the short term, effective governmental assistance to workers who are displaced by increased trade flows can help considerably. This assistance should have two components: stronger safety nets to cushion the transitional costs of job displacement, and more effective training and other adjustment programs to help workers qualify for new positions.

Acting on such evidence, Congress insisted that its authorization of new trade negotiations in 2002 be linked to substantial improvement in the Trade Adjustment Assistance program, which has pursued these goals since 1962. The new legislation broadened eligibility for the program, provided more generous levels of aid (especially for job-search and relocation expenditures), and established innovative wage insurance (to cover lost income when workers accept lower-paying jobs) and health insurance improvements. Unfortunately, in its first term the Bush administration (like its predecessors) has failed to implement these programs aggressively. The next administration must do so, in addition to developing other programs to alleviate the negative impacts of liberalization. Coverage should be broadened and benefits increased. There should be more effective support for adjustment, such as lifelong learning programs. Other innovations should include asset-value insurance, full portability of health and pension benefits, and a new "Human Capital Investment Tax Credit" to induce companies to provide more on-the-job training.

The economic gains from globalization to the United States are so large that it can readily afford to set aside a small portion of the proceeds to take care of those who lose out in the process—and basic norms of justice require that it do so. The United States will be unable to build a sustainable political base for a constructive foreign economic policy until it decisively addresses the adverse domestic consequences of globalization.

 

Energy Drain

Energy is another area in which the United States is vulnerable, in both economic and foreign policy terms. The lack of an effective energy policy—highlighted once again by the recent failure of Congress to pass adequate legislation after three years of effort—keeps U.S. foreign policy beholden to a few key producers and will probably force the United States to continue to launch periodic military interventions to satisfy its tremendous appetite for energy.

The leaders of the Organization of Petroleum Exporting Countries (OPEC) are allowed to manipulate world energy prices, holding them 50 to 75 percent above market levels in recent years. As a result, the cost of energy as a share of U.S. GDP has tripled since 1997. Since the oil shocks of the 1970s, prices have ranged from 15 to 300 percent of competitive levels, averaging almost double the competitive price. (In addition, as Alan Greenspan noted, the three major U.S. recessions prior to the shallow decline in 2001 "have all been preceded by spikes in the price of oil.") Over this period, inflated energy costs have depressed the U.S. GDP, and those of other oil-importing countries, by 15 to 30 percent. Restoration of market energy prices could alone boost economic growth by one percent a year.

Fortunately, as energy economist Philip Verleger has pointed out, consuming countries now have the capacity to counter the influence of producers. Strategic inventories now exceed 1.2 million barrels, including over 600 million held by the United States alone. These holdings make it possible for consumers to drive prices down until they better reflect the market and to keep them there, by using inventories as price stabilizers rather than thinking of them solely as protection against supply disruptions (which did not occur during either of the wars with Iraq). It is sheer folly for the United States to invest billions of dollars in its petroleum reserves only to sit on them as producers drive up prices.

Any new campaign to cut world oil prices would inevitably invite charges of being part of a broader anti-Islamic crusade. It would be essential, for political as well as economic reasons, that the initiative be multilateral. The Organization for Economic Cooperation and Development's International Energy Agency (IEA) could manage the effort, with maximum efforts to include China and other oil-importing nations. It should, moreover, be emphasized loudly and repeatedly that large Muslim countries, notably Pakistan and Turkey, would also benefit from lower energy prices.

Oil-consuming countries should offer OPEC a producer-consumer agreement before threatening it with the prospect of sales from strategic stockpiles. The lead producers limit supply and push for higher prices in part because they fear a future loss of market share to Russia, Iraq, and western African countries. The IEA could agree to create mechanisms to provide OPEC countries, particularly those in the Persian Gulf, with a guaranteed market while at the same time offering oil to consumers at prices much lower than what they currently pay. Such an agreement should include larger global oil inventories and a system to share future production cuts, should prices drop too far, among all the major suppliers (rather than just a few cartel members).

The U.S. position would obviously be strengthened greatly if the United States finally took serious steps to limit its own consumption of energy. The most straightforward way to do so would be to target the most energy-intensive sector, transportation, by raising corporate average fuel economy standards, particularly as they apply to SUVs and light trucks. A sizeable carbon or gasoline tax would help enormously and also reduce the budget deficit.

There is, of course, a direct link between these energy proposals and the war on terrorism. A large portion of terrorist financing comes from Middle Eastern countries that benefit from the institutional arrangements that keep oil prices high. The United States' disregard for rigged oil prices is a gap in the antiterrorism campaign, as well as a major drain on the U.S. economy, and it should be remedied as soon as possible.

 

Instituting Change

New institutions will be needed to conceptualize and implement new policies. At the international level, one key requirement is for the United States and the EU, the world's two economic superpowers (together accounting for well more than half of the global economy), to create a "G-2"—an informal steering committee to manage the world economy and their bilateral relationship.

Although a transatlantic free trade area would be a bad idea, discriminating against the world's poorest countries, close and continuing cooperation between the United States and the EU is necessary for global economic progress. The G-2 would operate informally and would not undermine any other multilateral institutions or associations. Indeed, it would even contribute to a revitalization of such institutions. The G-7 nations, for example, could become the G-3 (the United States, the EU, and Japan) or, eventually, the G-4 (when China is ready to join).

To start, both the United States and the EU should be much more forthcoming with offers to liberalize trade in order to restart the Doha Round. (Their grossly inadequate positions at Cancún led to the current breakdown.) Conflicts over other bilateral issues could also be resolved more easily if they saw themselves as responsible co-leaders of the world economy rather than tit-for-tat antagonists. And cooperation on new economic initiatives would help patch up the political rift opened by the Iraq war. It would serve as a response to a new economic bloc in East Asia, and it could help strengthen the ability of global institutions such as the IMF and the WTO to maintain a multilateral check on new regional steps. The deep economic interpenetration of the United States and Europe—with $500 billion in direct investment in each direction and $400 billion in annual trade—is the main force holding them together. A G-2 initiative would thus have broad benefits for overall foreign policy.

A new institutional approach is needed at home as well. In recent years, foreign economic policy has devolved into a series of uncoordinated, ad hoc decisions, despite the obvious need to coordinate foreign policy with economic policy. Taxes are slashed and vast budget deficits created with little thought for their impact on the U.S. global economic position or international financial vulnerability. The Treasury Department fulminates against bailouts of emerging market economies before meekly complying with White House orders to support the same bailouts for foreign policy reasons (as in Argentina, Brazil, and Turkey). The U.S. Trade Representative is relegated to the sidelines in creating new steel tariffs or shaping the farm bill, despite their centrality to trade policy. Energy legislation is pursued with nary a word about how producer countries rig global prices and levy huge costs on our economy.

The Clinton administration created a National Economic Council to address such issues but never institutionalized the mechanism; it quickly fell into disuse when key personnel changed. A well-managed council, eventually written into law to parallel the National Security Council (NSC), is badly needed now. It would also help if at least one of the two top officials at the State Department and the NSC brought some economic expertise to their positions and were more cognizant of the importance of international economic issues to their broader mandates.

Congress must also get its act together on foreign economic policy. In an earlier era, similar global imperatives, the salience of which is underlined by current events, prompted the creation of the Senate and House intelligence committees to amalgamate foreign policy, national security, and related domestic concerns. The creation of similar committees on globalization could bring together the leadership of the trade committees (Ways and Means in the House, Finance in the Senate), those responsible for international finance, some of the relevant special committees (agriculture and commerce), and the foreign policy committees.

 

The Prospects for Progress

The United States has great economic strengths. It remains by far the world's largest national economy. Its sharp growth in productivity over the past decade appears likely to continue and perhaps accelerate again, generating very rapid expansion for a mature industrialized country. Moreover, it is growing much faster than other industrialized economies. The dollar will continue to be the main global currency for some time, and the U.S. model of capitalism and globalization dominates thinking around the world.

Yet the next president will face unprecedented challenges in the conduct of foreign economic policy. The case for globalization will have to be made persuasively, forcefully, and repeatedly. Domestic support could crumble if the president fails to address its internal costs with new safety nets and opportunities for skill enhancement; international support could dissolve if the White House's strategy fails to offer reciprocal benefits to other countries or is conducted without full consideration of their concerns. Such an outcome would be extremely costly. The economy would suffer from trade restrictions and a plummeting dollar in the short term and from reduced productivity growth in the long term. Foreign policy, meanwhile, would be jeopardized if the United States retreated from constructive cooperation with other nations on issues at the top of their agendas.

Most important, foreign economic policy could rescue overall U.S. foreign policy. The United States' biggest problem in the international arena is its tendency to act unilaterally on a range of issues. Such unilateralism is demonstrably ineffective and thus thankfully rare in the economic domain. The international economic initiatives proposed in this essay would convey a new image of U.S. foreign policy while furthering U.S. national interests. They should rank high on the agenda of the next U.S. president.


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