Decreasing returns to scale

From Croatia and Uruguay to Denmark and Sweden, small countries at the World Cup are showing that small size is not a major constraint on performance (even if Iceland were unable to make it through).  Being a football superpower does not buy you much anymore: talk to Germany – or indeed to Italy, who failed to qualify.

But this reality is not confined to football.  Power is a slippery concept.  As Moses Naim wrote in The End of Power, ‘being in charge isn’t what it used to be’.  In a more complex world, large powers are increasingly constrained by smaller challengers, finding it more difficult to exert power.

Globalisation and an increasingly broad distribution of economic power has effectively made all countries small.  External events intrude further into domestic affairs, and it is increasingly difficult for even the largest economies to exercise full policy autonomy – or to project power.  This is one of the reasons for domestic political frustration in many countries – voters want to ‘take back control’.   And it also has implications for understanding how national policy responses will play out.

First, there is a high risk that large countries over-estimate their effective size or power and make costly decisions.  Making American Great Again is an explicitly nostalgic agenda, but the world has moved on.  Using the US/Japan trade disputes of the 1980s as the template – which is what many in the Trump Administration seem to be doing – is misleading.  The economic and political relativities between the US and Japan in the 1980s are not the same as those between the US and China today.

Mr Trump is over-estimating the negotiating position of the US; the US cannot just steamroll China or the EU.  This will also be a costly process for the US – the Harley Davidson decision this week is just one example.  And the risk is that frustrated large powers subsequently reach for bigger weapons, such as exchange rate intervention (and leaning on the Fed).  But the ability of the US to impose a Plaza Accord style resolution is no longer possible as it was in 1985.  It is a much different world than 1999, when Time Magazine could feature the American triumvirate of Alan Greenspan, Larry Summers and Bob Rubin as ‘the committee to save the world’.

The US will pay a long-term cost, accelerating the transition from its central economic and political position (including its reserve currency status).  This is disguised in the short-term because of macro stimulus, but the tectonic plates are moving.

Brexit is another example of the costs of countries (voters) over-estimating their national place in the world.  The direction of travel increasingly looks like little England rather than global Britain. I remain confident that a fudged, soft Brexit solution will be found, but this is a lot to pay for obtaining a worse version of the status quo ante.

The US and UK are not the only countries over-reaching.  The more assertive economic and political behaviour from China is another concerning trend; as are the actions of various autocratic regimes, from Turkey to Russia.  Reality will bite for these countries as well – in the short-term, as much from market discipline as from political forces.

Second, bystander countries can get hurt by the hubristic decision-making of large countries.  I wrote last year that large countries over-estimating their size would be a major source of global economic and political risk.  Although big powers may not be big enough to exert themselves in an unconstrained way, they are big enough to impose costs on others.  The OECD and IMF continue to note that the global economic outlook is sensitive to decisions made by large countries.

For example, trade conflict between large powers is a material economic risk.  My assessment is that these trade and investment tensions will be a central feature of the global economy for some time.  Similarly, there are material domestic political risks in major countries – from the US and China, to populism in countries like Italy – that could have international economic spillovers.  Markets have been too sanguine on where this is heading, and the recent repricing of these risks is appropriate.

The third implication is that without big powers no one is in charge – the G-zero world.  With no global or regional hegemon, reaching consensus on global issues – from financial stability to trade policy – becomes much more challenging.  This makes the global economy a riskier environment.  Countries are unable (and unwilling in some cases) to provide leadership. After the spectacular failure of the G7 Summit in Canada, it is very hard to imagine a coordinated policy response in the way that the G20 supported international policy efforts to the global financial crisis a decade ago.  Indeed, the US continues to actively undermine multilateral institutions such as the WTO.

And in Europe, France and Germany – traditionally the engine room of decision-making – are struggling to deliver reform.  This is partly due to differences between France and Germany, but also because of concerns from the growing Northern European alliance of small states.  These constraints on large powers can be a good thing – large countries do not always get things right – but it makes progress more complex.

This regime change to a more multipolar, centrifugal world will be bumpy, as governments (and electorates) take time to adapt to new realities.  This lowering of the decision-making centre of gravity will be a defining feature of the global economy alongside the shift from West to East.


David Skilling