American Foreign Policy: A Review, Part II

American Foreign Policy: A Review, Part II

Last week, in Part I of this study, we examined the four imperatives of American policy with an elaboration of each one. This week, we will discuss why each is important. We will examine why there has been a “drift” in American foreign policy since the end of the Cold War. This drift has now reached a critical point as the U.S. appears to be backing away from its postwar trade policies and the geopolitical imperatives that avoided WWIII. As always, we will conclude with the impact on financial and commodity markets.

The Importance of the Imperatives

To review, the U.S. had four geopolitical imperatives after WWII. They were:

1. Deal with the Soviet Union, in particular, and the threat of global communism, in general
2. Maintain peace in Europe
3. Maintain stability in the Middle East
4. Maintain peace in the Far East

All four of these imperatives were critical to maintaining global peace. Preventing the expansion of communism was “job one,” but removing the “German problem” from Europe was also very important as was keeping tensions manageable between China and Japan. Although it was difficult to justify supporting authoritarian regimes in the Middle East on moral or ethical grounds, it was necessary to maintain stability. Essentially, American foreign policy was designed to contain communism and freeze three potential conflict zones in Europe, Asia and the Middle East.

All of these imperatives require sacrifice. To bind Europe and Asia to the U.S., open (rather than free) trade was embraced; both Germany and Japan established economic policies that were the mirror image of American policy. These recovering nations suppressed consumption and maintained undervalued exchange rates in order to create trade surpluses that the U.S. absorbed. It allowed both nations to recover from the devastation of WWII, remain in the free world and become economic powers in their own right. Other nations followed this policy mix with positive results. A series of nations around the world adopted similar policies that allowed them to develop using the reliable demand from the American consumer.

Until the 1970s, the U.S. economy was proportionally large enough to absorb these imports with little impact on employment. However, as the size of the U.S. economy has shrunk relative to the rest of the free world, employment began to be adversely affected. To some extent, the U.S. was a victim of its own success.

The supply-side policies of the Thatcher/Reagan revolution led to increased globalization, outsourcing and the rapid introduction of disruptive technology. These policies were remarkably successful in reducing inflation from 1965 through the 1980s. However, this drop in inflation came at the cost of increasing U.S. income inequality. In order to maintain enough spending to fulfill the reserve currency role in the face of falling incomes, the U.S. deregulated its financial system and supported debt accumulation.

This chart shows the level of consumption that could be funded by worker compensation (lower line) and the household debt/GDP ratio. Until the early 1980s, compensation would fund 90% to 95% of household consumption. Since then, the ratio has steadily declined, now only funding about 78% of consumption. The rest is funded by transfer payments and debt (the debt statistic shown on the upper line). Household debt to GDP almost reached 100% at its peak; deleveraging since the financial crisis has reduced this ratio to 78.4%. Although there is no “magic ratio” of debt/GDP that completely signals sustainability, we estimate that a ratio around 60% is probably maintainable at normal interest rates.

The security requirements of the four imperatives were also costly. The next chart shows U.S. defense spending as a percentage of GDP. Prior to the Cold War, defense spending tended to track wars; during wars, the U.S. would mobilize its military and demobilize once the conflict ended. During the Cold War, spending remained permanently elevated to meet the aforementioned imperatives.

The reserve currency role and military spending represented global public goods supplied by the U.S. economy. There are benefits Americans receive from these factors, such as the fact that the U.S. can run trade deficits with little fear of currency problems due to the natural demand for dollars that comes from the reserve currency role. However, it does endanger industries that compete globally and leads to higher U.S. unemployment as industries find themselves facing withering foreign competition.