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A New Era of Geo-economics: Assessing the Interplay of Economic and Political Risk

IISS Seminar 23-25 March, 2012

INTRODUCTION: Understanding Geo-economics and Strategy

Sanjaya Baru
Director, Geo-economics and Strategy, IISS

Introduction I. What is Geo-economics?

Geo-economics may be defined in two different ways - as the relationship between economic policy and change on national power and geo-politics - in other words, the geopolitical consequences of economic phenomenon, or, as the economic consequences of geopolitical trends and national power. Both the notion of trade follows the flag, that there are economic consequences of the projection of national power, and the idea that the flag follows trade, that there are geopolitical consequences of essentially economic phenomena, would constitute the subject matter of geo-economics. Either way, the intellectual roots of geo-economics are embedded in seventeenth century European, largely French, mercantilism. The military pursuit of markets, resources and bullion for a country to be able to export more and import less, buy cheap and sell dear preceded the advent of modern economics based on ideas of free trade and laissez-faire. While the nineteenth century was dominated by these ideas of classical political economy, mercantilism was never buried and has repeatedly raised its head, in inter-war Europe of the 1920s and 1930s and most recently in China. In the 1980s, the rise of Japan elicited mercantilist responses from Europe and the United States based on fears that Japan had in fact risen on the back of mercantilism. More recently, the crises in Europe and North America have revived latent mercantilism, with many accusing Germany and the United States of pursuing a mercantilist agenda. In the post-war era, from 1950 to 1990, international economics and politics were marked by a conflict between the ideas of free trade and liberal democracy, on the one hand, and those of etatism and authoritarianism on the other, with a few countries experimenting with a mix of the two, some mixing liberal democracy with state capitalism (like India) and others mixing free enterprise with military or one-party rule (like the Asian Tigers and many Latin American countries). However, the dominant paradigm in this period, the Cold War era, was one in which politics remained in command and geopolitics was driven by ideological rather than purely economic factors. It is, therefore, not a coincidence that the three most important ideas defining contemporary geo-economics were all articulated at the time when the Cold War was on the verge of ending or had just ended and a new era of economic rivalry between nations was inaugurated. The first important articulation of the contemporary geopolitical consequences of post-War economic trends was Paul Kennedys study of The Rise and fall of Great Powers (1987) that put forward the thesis of imperial overstretch, drawing attention to the fiscal and other economic limits on national power and its projection. Its prescient character is underscored by the fact that it was written at a time when the Cold War had not yet formally ended. As Kennedy put it: ... all of the major shifts in the worlds military-power balances have followed alterations in the productive balances; and further, that the rising and falling of the various empires and states in the international system has been confirmed by the outcomes of the major

Great Power wars, where victory has always gone to the side with the greatest material resources. 1 The second important articulation of the idea of geo-economics was the 1990 essay of Edward Luttwak, From Geopolitics to Geo-economics: Logic of Conflict, Grammar of Commerce. Luttwak observed: Everyone, it appears, now agrees that the methods of commerce are displacing military methods with disposable capital in lieu of firepower, civilian innovation in lieu of military-technical advancement, and market penetration in lieu of garrisons and bases. States, as spatial entities structured to jealously delimit their own territories, will not disappear but reorient themselves toward geo-economics in order to compensate for their decaying geopolitical roles. ...... geo-economics is the best term I can think of to describe the admixture of the logic of conflict with the methods of commerce. It was an argument that drew attention to the nascent neo-mercantilism of the Cold War era, especially on the part of Japan and the architects of the European common market that began to worry the United States. The logic of conflict in the methods of commerce was not visible in the statecraft of either the decaying Soviet Union or the as yet dormant China. Rather, it was seen in the aggressive export-led growth models of Japan and the Asian Tigers, and in the creation of the European Economic Community. A more forthright articulation of this view was made by the third intervention in 1993 of Samuel Huntington. His essay, Why International Primacy Matters (1993), extending Daniel Bells assertion that economics is the continuation of war by other means (1990), set out a bold hypothesis:
In the coming years, the principal conflict of interests involving the United States and the major powers are likely to be over economic issues. US economic primacy is now being challenged by Japan and is likely to be challenged in the future by Europe. Obviously the United States, Japan and Europe have common interests in promoting economic development and international trade. They also, however, have deeply conflicting interests over the distribution of the benefits and costs of economic growth and the distribution of the costs of economic stagnation or decline. The idea that economics is primarily a non-zero sum game is a favourite conceit of tenured academics. ..... Economists are blind to the fact that economic activity is a source of power, as well as well being. It is, indeed, probably the most important source of power and in a world in which military conflict between major states is unlikely economic power will be increasingly important in determining the primacy or subordination of states. In the realm of military competition, the instruments of power are missiles, planes, warships, bombs, tanks and divisions. In the realm of economic competition, the instruments of power are productive efficiency, market control, trade surplus, strong currency, foreign exchange reserves, ownership of foreign companies, factories and technology.

Paul Kennedy, The Rise and Fall of the Great Powers: Economic Change and to Military Conflict From 1500 2000 , Random House, New York, 1987, p. 439. (Italics in the original, underscoring ours)

The end of the Cold War coinciding with the rise of a new Japan shaped the view that a new era of geo-economics was upon us. 2


Post-Cold War Geo-economics

The implosion of the Soviet Union was in itself the most important geo -economic phenomenon of the post War period. Long before the Soviet Union actually dissolved itself the economic basis for its dissolution was laid as the Russian economy began to falter. Few analysts actually predicted the dissolution of the Soviet Union, and even as late as 1987, Kennedy summed up his analysis of the paradox of Soviet economic decline and military build up thus: This does not mean that the USSR is close to collapse, any more than it should be viewed as a country of almost supernatural strength. It does mean that it is facing awkward choices.......It is to be expected that the efforts and exhortations to improve the Russian economy will intensify. But since it is highly unlikely that even an energetic regime in Moscow would either abandon scientific socialism in order to boost the economy or drastically cut the burdens of defense expenditures and thereby affect the military core of the Soviet state, the prospects of an escape from the contradictions which the USSR faces are not good.3 While few appreciated the inevitable geo-political consequences of Russian economic decline, political fears related to Japans economic rise now appear exaggerated. Huntington in fact theorised on what he called the Japanese strategy of economic power maximisation, identifying five sources of such power: (a) Producer Dominance opting for economic power over well-being; (b) Industry Targeting building manufacturing capability and capacity both for a home and an export market, with a focus on strategic, high-technology and high valueadded industries; (c) Market Shares over Profits a deliberate strategy to invest in losses for the sake of ultimate domination of an industry; (d) Import Restriction placing curbs on imports and inward foreign direct investment; and, (e) Sustained Surplus building foreign exchange reserves through sustained trade surplus and by intervening in currency markets with the intention of maintaining a strong currency. Given his preoccupation with culture and the conflict between civilisations it was not surprising that Huntington took a dim and worrisome view of Japans rise. Huntington quotes Sonys co-founder Akio Morita as saying, We are going to have totally new configuration in the balance of power in the world. The time will never again come when America will regain its strength in industry. Japan was seen in the late 1980s as China has come to be in the late 2000s the neo-mercantilist and geo-economic power of the day.

See, for example, Mark P. Thirlwell, The Return of Geo-economics: Globalisation and national Security, Lowy Institute for International Policy, September 2010. Available at: Klaus Solberg Soilen, The shift from Geopolitics to geoeconomics and the failure of our modern Social Sciences Electronic Research Archive of Blekinge Institute of Technology, ; Michael D. Ward and Peter D. Hoff, Analysing Dependencies in Geoeconomics and Geopolitics, 2007. 3 Kennedy (1987), p. 513 (italics in original)

Europe responded to Japans geo-economic challenge with the creation of the European Single Market. Paollo Cecchinis report on the costs of Non-Europe was written against the background of Japans growing competitiveness and the European fear of losing global market shares to Japanese and United States firms. 4 Interestingly, notwithstanding its rise as a major economic power, the worlds second largest economy, Japan did not emerge as a geo-economic power, having failed to convert its new economic clout into military and political power. Thus, a Japanese initiative to stitch together a new regional grouping, the East Asian Economic Group, canvassed vigorously by Malaysia on behalf of Japan, failed to take off. In 1995 Japan made a concerted bid to secure the leadership of the International Monetary Fund (IMF), sponsoring the candidature of the governor of the bank of Japan, Toyoo Gyohten, and failed. It followed this up with the idea of creating an Asian Monetary Fund and that too was rebuffed. While in 1988-90 Japan was viewed as a new challenger to Europe and the United States, by the mid-1990s it was clear that Japan was still unable to convert its economic power into geo-political power. As Thirlwell put it, Japans challenge was fading fast. And as the supposed competitive threat from Japan started to recede, so did the attractions of geo-economics. 5 German reunification, also a consequence of the end of the Cold War, had geo-economic consequences in terms of the expansion of the European Union (EU) and a surge towards greater economic and monetary integration within the EU. However, because of Germanys preoccupation with the management of that re-unification, there were limited geo-political consequences as far as Germany itself was concerned. Rather, the focus was on the EUs geoeconomic and geo-political role in world affairs. This contrasts with what is happening now, with Europes fiscal crisis offering Germany greater geo-political space. We return to this idea later.


The Geo-economics of the Asian Financial Crisis

The really important geo-economic event of the post-Cold war period was the Asian financial crisis of 1997-98. That crisis began in Thailand in the summer of 1997 with speculative attacks on the Thai Baht. Within months it engulfed several Southeast Asian and East Asian economies including Indonesia and South Korea. While the IMF responded in a predictable manner, as it did in Latin America, Russia and India in the early 1990s, China stepped in to offer support and subsequently leverage its geo-economic power. Thus, Chinas first step was to extend a line of credit to Thailand to enable it to defend the Thai Baht. After an overnight offer of a billion dollars to Thailand, China provided an additional US$3.5 bn through the IMF to other Asian economies. In the following months China ensured that the renminbi remained a rock solid currency, with no change in exchange rate even as almost all other Asian currencies devalued.

Paolo Cecchini, The European Challenge, 1992: The benefits of the Single Market, Wildwood House, 1988. 5 Thirlwell (2011), p. 10

Summing up Chinas actions during the crisis, the Chinese foreign ministry claimed:
To ease off the financial crisis, the Chinese Government adopted a series of pro-active policies. They included: It actively participated in the IMF-organized aid projects for some Asian countries. In the wake of the financial crisis in 1997, the Chinese Government provided Thailand and other Asian countries with over 4 billion US dollars in aid, within the framework of IMF or through bilateral channels. It offered Indonesia and other countries export credit and emergency medicine given gratis. The Chinese Government, with a high sense of responsibility, decided not to devaluate its Renminbi in the overall interest of maintaining stability and development in the region. It did so under huge pressure and at a big price. But it contributed considerably to the financial and economic stability and to the development in Asia in particular and the world at large. While sticking to its non-devaluation policy, the Chinese Government adopted the policy of boosting domestic demand and stimulating economic growth. This policy played an important role in ensuring a healthy and stable economic growth at home, easing the pressure on the Asian economy and leading it into recovery. China actively participated in and encouraged regional and international financial cooperation together with the relevant parties. 6

A payments crisis was followed by a banking and financial crisis that was in turn followed by an economic slowdown that had internal political consequences for the countries involved and geopolitical consequences for Asia as a whole. 7 China emerged as a major exporting power with the rest of the world but as an importing power in Asia. Altering the so-called Flying Geese pattern of export-led industrialisation in Asia, China became an exporter to the West, to North America and Europe, and an importer within Asia of goods, resources, technology and capital. By the time China entered the World Trade Organisation in 2001, with United States support, it had already become a major trading nation and a geo-economic power. The subsequent decade has seen China emerging as a resources guzzler, with its own geo-political consequences. The Asian financial crisis, therefore, contributed to Chinas rise as the original Asian tigers faltered and the regions laggard economies became increasingly dependent on the Chinese economy.


Geo-economics of the Trans-Atlantic Financial Crisis

While the Asian financial crisis consolidated Chinas power in Asia, the trans-Atlantic financial crisis has had the effect of consolidating Chinese power globally, though it has not led to a new

Pro-Active Policies by China in Response to Asian Financial Crisis, 17/11/2000. Ministry of Foreign Affairs, Beijing. Accessed at: 7 For a detailed discussion of the geo-economics and geo-politics of the Asian financial crisis see Ch. 30, The Asian Economic Crisis and Indias External Economic Relations, in Sanjaya Baru, Strategic Consequences of Indias Economic Performance, Routledge, 2007.

bipolarity referred to as G-2. 8 The restructuring of the share-holding of multilateral financial institutions, especially the IMF, the creation of a new regional architecture in Asia through the Chiang Mai Initiative Multilateralization (CMIM) and the creation of an Asian bond market have all enhanced Chinas economic power globally. If China was the geo-political beneficiary of the Asian financial crisis, Germany has emerged as the geo-political beneficiary of the European debt crisis. Germany has deployed its economic and financial power in Europe to acquire political power in Europe of a kind that it has not enjoyed in a long time. Kundnani summed it up succinctly:
The concept of geo-economics now seems particularly helpful as a way of describing the foreign policy of Germany, which has become more willing to impose its economic preferences on others within the European Union in the context of a discourse of zero-sum competition between the fiscally responsible and the fiscally irresponsible. For example, instead of accepting a moderate increase in inflation, which could harm the global competitiveness of its exports, Germany has insisted on austerity throughout the eurozone, even though this undermines the ability of states on the periphery to grow and threatens the overall cohesion of the European Union. In Luttwaks terms, Germany is applying the methods of commerce within a logic of conflict. 9

Both China and Germany have deployed exchange rate policy as a means to enhance their geoeconomic power. Chinas consistent under-valuation of the Yuan has been widely viewed as a mercantilist intervention. However, few have commented on Germanys rigid stance on the Euro which has clearly hurt some European economies, just as Chinas currency policy has hurt its Asian neighbours, while allowing Germany to remain globally competitive. Implicit in Chinas and Germanys exchange rate policy is a beggar-my-neighbour strategy that has helped both countries generate high current account surplus, while shifting the burden of adjustment to neighbouring economies. Both China and Germany appear to have succeeded where Japan failed, namely, convert their economic clout into regional political influence, if not as yet global influence. Both have made good use of a regional financial and economic crisis to shift the regional balance of power in their favour. In doing so, they have also shifted the global balance of power in their favour. They are the geo-economic powers of our times.


Structural Shifts and Economic Shocks

The rise of China and indeed of other newly industrialising economies of Asia, as well as the rise of other Emerging Economies, denotes a structural shift in the locus of growth in the world

Sanjaya Baru, India: Rising through the slowdown, in Ashley J. Tellis, Andrew Marble and Travis Tanner, (Eds). Strategic Asia 200910: Economic Meltdown and Geopolitical Stability, National Bureau of Asian Research, Seattle, US. Accessed at: 9 Hans Kundnani, Germany as a Geo-economic Power, The Washington Quarterly, Summer 2001. p41. Accessed at:

economy. This constitutes an enduring geo-economic shift that has already had and will continue to have geo-political consequences, with attendant political risks and opportunities. This structural shift must, however, be distinguished from economic shocks, like a financial crisis or an energy shock, that can have their own geo-economic consequences, sometimes accelerating the underlining structural shifts, sometimes slowing them down. There are four long-term factors contributing to the more enduring structural shifts in the global economy. There are, thus, four essential attributes of geo-economic power: Firstly, knowledge power and demographic transition; secondly, agrarian transformation and search for resources; thirdly, social and political transformation, especially the rise of a middle class and of entrepreneurial classes; finally, fiscal capacity to fund military capability. 1. The empires of the future, observed Winston Churchill in 1946, will be the empires of the mind. Knowledge, that is human capability, is the single most important attribute of power in the modern world. Long term demographic shifts can alter the dynamics of knowledge power and have both geo-economic and geopolitical consequences. The decline of Japanese power, vis-a-vis China for example, is writ into its demographic structure. So also the rise of India. Long term demographic shifts, if accompanied by investment in human capabilities, can shift the production possibility frontier of economies in decisive ways. Countries that are open to in-migration, like the United States, can ward off the consequences of such demographic shifts. However, less pluralistic and open societies may be at a disadvantage, but have the potential to emerge as knowledge powers. 2. Agrarian transformation has several geo-economic effects. Most importantly, it accelerates the pace of economic growth, facilitates industrial development, and helps ensure food security. Countries with assured access to natural resources have an advantage over those dependent on imports for vital resources, especially food and energy. 3. The rise of an urban middle class and an entrepreneurial class is an important requirement of sustained and sustainable long term economic growth. Economic institutions and governance are critical determinants of these phenomena. 4. The fiscal empowerment of the State, a consequence of high growth and improved governance, creates the fiscal resources required both for welfare and infrastructure spending and for building technological and military capability. 10 Each of these is an important determinant of geo-economic and geo-political power of a country. These are, however, long term structural factors and there can be year to year fluctuations in the ability of countries to address these challenges. Long term projections of national power will have to be based on likely trends in each of these phenomena. Analysts at the China Academy of Military Sciences have long sought to measure Comprehensive National Power based on such geo-economic phenomenon as domestic economic capability, scientific and technological capability, social development, government capability and so on. 11
Kautilya wrote in his Arthasastra (circa 400 BC) that From the strength of the treasury the army is born. An idea that informs Kennedys theory of imperial overstretch and Fergusons hypothesis about the square of power in Niall Ferguson, The Cash Nexus: Money and Power in the Modern World , 1700-2000, Allen Lane The Penguin Press, 2001. 11 Conceptualising economic security(Ch.3) in Sanjaya Baru (2007). p76

While being mindful of such long term trends, the analysis of economic and political power and risk must at any point in time must be based on near term ability of nations to deal with economic shocks that could have an impact on these long term trends. A financial or fiscal crisis can have serious implications for long term growth and comprehensive national power. The Asian and trans-Atlantic financial crises, as well as the European debt crisis, have had the effect of either accelerating or decelerating these long term structural shifts. An energy shock would have a similar impact on national capabilities. In trying to understand the interplay between economic and political risk one must make a distinction between the risk of structural shifts that are predictable and against which nations can seek insurance through planned policy intervention and the risk of economic shocks that may be less amenable to planned policy intervention. The latter would of course impact on the former and vice versa. In its analysis of Global Risks 2012 the World Economic Forum lists five different types of risks economic, environmental, geopolitical, societal and technological. 12 It is easy to see that not all are risks of the same type from a policy and time perspective. In the short run, policy intervention can deal with certain types of risks and not others. Thus, Europe can formulate a policy response to its debt crisis, but can do very little to offset the likely impact of the demographic transition. A water supply crisis, which is ranked as the fifth most important global challenge, after severe income disparity, chronic fiscal imbalances, rising greenhouse gases and cyber attacks is not as easily addressed in the short term as the other top four sources of risk. Further, the ability of governments to deal with one risk is contingent upon its ability to deal with another. Thus, chronic fiscal imbalances can be mor e easily addressed if governments have the political mandate and will to redress severe income disparities. Nowhere is the interplay between political and economic risk more obvious than in national policy. Governments faced with economic challenges at home constantly weigh the political pros and cons of various policy options. In the end, it is the dynamics of power that shapes choice. In international affairs too there are similar choices to be made. Political choices, like a military attack on Iran, have economic consequences, like an increase in oil prices. Germanys ability and willingness to step in and help Greece is as much a function of the economic costs of such an intervention as of the political costs and the geo-political consequences. Geo-economics impinges upon geopolitics as much as economics impinges upon politics. Power is as much a function of prosperity as prosperity is a function of power. There can be episodic disengagement between the two. That is, a country may be able to exercise or project more political or military power than is warranted by its true economic capability. The Soviet Union of the 1970s is a good example. Similarly, a prosperous country may be able to exercise influence in excess of its military and geopolitical power. Japan of the 1980s is a good example.


World Economic Forum, Global Risks 2012, Geneva, 2012.

Neither has been able to sustain this imbalance between economic and political power because they lacked the four elements of geo-economic power.

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