Economic statecraft has a long history. Thucydides tells us that Pericles sponsored the Megarian decree of 432 BC, prohibiting Megarians from accessing the markets and harbours of the Athenian Empire (or Delian League). The purpose of what today would be called an embargo was to weaken a Spartan ally and to provoke Sparta. Sure enough, the Peloponnesian War started only a year later.
England adopted the Navigation Act in 1651. It prohibited foreign ships from entering English ports and it largely monopolised trade with the colonies, seeking to establish self-sufficiency. The Navigation Act was repealed in 1849, together with the Corn Laws (1846), as England moved from mercantilism to free trade. The Megarian decree is an instance of economic statecraft, while the Navigation Act is best construed more narrowly as economic policy. The line between economic statecraft and economic policy can and often is a thin one.
Economic statecraft is the use of economic instruments to advance broader foreign policy objectives. Economic statecraft comprises commercial, financial and monetary policies and instruments. Economic policy does not equal economic statecraft. To the extent that the Navigation Act meant to establish self-sufficiency and did not pursue broader foreign policy goals, it cannot be considered statecraft. The Megarian decree, by contrast, made conscious use of an economic instrument (trade) in pursuit of broader foreign policy goals.
Economic power is a pre-requisite for the exercise of successful economic statecraft. A state’s economic power is closely related to the concept of interdependence. Two countries that have no actual or potential economic or financial relationship whatever will find it difficult-to-impossible to use economic statecraft to directly influence another country. It does leave open the possibility to exercise indirect influence via third countries. “Asymmetric interdependence” (Keohane & Nye 1977), a constellation where state is more dependent – and hence more sensitive and vulnerable – to the actions and policies of another state than vice versa, is particular conducive to the exercise of economic statecraft on the part of the less sensitive and less vulnerable state. To the extent that economic statecraft uses carrots rather than sticks, interdependence may not be a necessary condition for its successful exercise. In this case, it would be the potential of forming an interdependent relationship that holds out the prospect of exercising power and gaining influence vis-à-vis another state (e.g. establishment of a mutually beneficial commercial or financial relationship through trade concessions or loans).
Economic statecraft works through “sticks” and “carrots”. Sanctions refer to the stick approach. Sanctions are a negative form of economic statecraft, as they impose (or threaten to impose) penalties in an attempt to change another party’s behaviour (“stick”). Sanctions involve the withdrawal of customary trade and financial relations for foreign and security-policy goals. Sanctions may prohibit a country’s companies and citizens from doing business with a blacklisted entity, whether it be a state, individual companies or selected foreign citizens (e.g. Megarian decree). Extra-territorial sanctions (or secondary sanctions) go further by seeking to restrict the economic activity of governments, companies and nationals of third countries in relation to the sanctioned or target country. This is often necessary in order to prevent third parties from weakening or even nullifying the impact of bilateral sanctions. Last but not least, so-called targeted or smart sanctions, for example, are often deployed to target individuals or companies rather than the country as a whole. This is seen as minimising the humanitarian costs of sanctions in the target country as well as the economic costs to the sender country. Economic statecraft can also be exercised by offering benefits to another state (“carrot”) such as improved market access or concessional finance (e.g. China’s BRI). In short, economic statecraft can involve both carrots and sticks and is generally intended to deter or coerce the target state in an attempt to realise the sender state’s foreign goals.
What determines a state’s economic power and its capacity to conduct successful economic statecraft in international affairs? Power is a complex and multi-faceted social phenomenon (Dahl 1957, Lukes 1974). So is economic power. As mentioned, economic power in international affairs is closely tied to interdependence and is therefore relational in nature. Interdependence describes a relationship that is characterised by costs and benefits. (Otherwise it would be mere interconnectedness.) A further distinction is made between sensitivity (costs/ benefits arising from a relationship) and vulnerability (ability of a state to affect the costs/ benefits arising from sensitivity). Actual (or potential) Interdependence is a precondition for the exercise of successful economic statecraft. An already existing relationship of asymmetric interdependence is better suited to impose costs and a potential relationship to offer benefits.
Economic power, like power more generally, comes in different forms, or it can be understood from different angles: power can affect decision-making, agenda-setting and preference formation (three faces of power), also known as decision-making, non-decision-making and ideological power (Bachrach & Baratz 1962, Lukes 1974); there is power-as-influence and power-as-autonomy; there is power-as-resources and power-as-influence; there is hard and soft (ideational) power (Nye 2004); there is structural and relational power (Strange 1971). In the context of economic statecraft, Dahl’s classic definition of power is typically the most relevant: A has power over B to the extent that s/he can get B to do something that B would not otherwise do. A state may use economic instruments to (threaten to) impose costs or to (promise to) offer benefits in an attempt to get B to do something it would not otherwise do. (This definition is consistent with both deterrence and coercion.) Other types of economic power matter in the international political economy. Power-as-autonomy is relevant in the context of international macroeconomic coordination (Henning 2005). Ideational power may have been relevant with regard to capital account liberalisation and structural economic reform (Abdelal 2007, Williamson 2004). Nonetheless, economic power in the context of statecraft is best understood as relational.
What are the sources of a state’s economic power in international affairs?
First, commercial or trade-related power is largely due to a combination of economic size and limited (but not zero) trade openness. If country A has a large economy and its trade with country B is limited, while country B is relatively smaller and more dependent on trade with A, then country A is well-positioned to exploit “asymmetric interdependence”, that is, country B’s trade dependence on country A. All other things equal, smaller economies are typically more open to trade than larger ones (Krasner 1976). Restricting or expanding market access, whether through tariffs, quantitative and regulatory restrictions, is key instrument of commercial statecraft and typically only available to relatively larger and relatively closed economies. The United States is the world’s largest economy (in nominal GDP terms) and it is also one the world’s least open economies. This is a major source of US power when it comes to commercial (or trade) statecraft.
Second, controlling the export of strategic goods provides states with the ability impose costs on others. A strategic good is a good that a country that imports it cannot easily find a substitute for (or can only do so at considerable cost). Export controls allow country A to restrict the supply of a strategic good to country B and this makes country B sensitive and vulnerable, absent an ability to mitigate its dependence on country A for the supply of the strategic good. The US can and does restrict the export of certain goods (e.g. technology). This gives it leverage as long as the target country is dependent on imports from the US and cannot easily substitutes for them. Put in economic terms, export controls are powerful tool in the case of (quasi-) monopolies and import restrictions are powerful tools in case of a monopsony (Hirschman 1945).
Third, large, deep, diversified, developed and open domestic capital markets are a source of state power and provide several tools of financial statecraft. Country B (and/ or its companies or nationals) may rely on country A’s financial and capital markets in order to raise capital/ foreign savings (import capital) or to invest capital/ domestic savings (export capital). Country A can introduce measures that prevent country B from both raising and investing capital. Such measures can be applied to all types of financial flows (and financial stocks), whether it be portfolio capital, foreign direct investment, loans or deposits. Restrictions can target existing stocks and future flows. Given the size of its capital market, country A will typically be little affected when sanctioning another, especially smaller country (and/ or its companies or nationals). And even if country B happens to be both large and a non-negligible source of capital for country A, country A arguably may retain substantial leverage under certain circumstances. At least, this is true in the US-China case due to China’s greater trade dependence and its dependence on the US treasury market for its foreign assets (Jaeger 2011, Posen 2009). Naturally, country A’s power is greater, the smaller and the more dependent country B is on financial market access. Moreover, while in theory capital is pretty fungible, that is, country B can try to raise capital elsewhere or hold its foreign assets in other jurisdictions, in practice the US has the largest, deepest and most liquid financial markets, not to mention the fact that it issues the world’s dominant reserve currency (Prasad 2014). This makes it difficult-to-impossible for country B to substitute financial access to country A with access to country C. Last but not least, financial restrictions can also affect FDI, including foreign takeovers and more generally the ability of companies controlled by country B to operate in country A (e.g. Huawei).
Fourth, the international use of one’s currency can be a significant source of power and influence. The international use of the dollar, including its use as a reserve currency by central bank, is based on a number of factors, including deep and liquid domestic financial markets (Jaeger 2010). While a strategic-selective default by the United States government on its dollar-denominated obligations held by specific foreign entities (e.g. central banks) is unlikely to ever become a credible tool of statecraft during peacetime, restricting and prohibiting the use of the dollar as a means of payments is (and has been). By prohibiting US entities from transacting with the target country, the US can cut off an important source of dollar liquidity. Extending the prohibition to third-country entities by threatening to exclude any foreign financial institution that continues to transact with the target country from accessing US dollar liquidity, the US can impose effective secondary sanctions. Prohibiting third-parties from transacting with a target country has proven quite effective in terms of imposing significant economic costs (Zarate 2013, Nephew 2017).
Fifth, monetary (or currency) statecraft refers to a government’s management of its exchange rate. US monetary power is due to economic size, financial development, effective governance as well as non-economic factors such as foreign policy ties and military power. It is these factors that allow a country to become a reserve-currency-issuing country with all the influence and power that comes with it. The US as the world’s foremost reserve currency country has the power to delay (continuing adjustment costs) and the power to deflect (transitional adjustment costs) (Cohen 2018). This effectively removes (or massively limits) the United States’ balance-of-payments constraint providing it with significant leeway to run up debt. This is more akin to power-as-autonomy. (As Dahl observed, “the logical complement of power is autonomy”.) But by making the US more autonomous it also makes it less vulnerable to the action of other countries and so surreptitiously enhances its relational power, too.
As far as monetary statecraft is concerned, the US can make use of the dollar in relational power terms. Monetary statecraft can involve the intentional, public, purposive management of country A’s currency in an attempt to get country B to change its macroeconomic policy (Cohen 2006). Sometimes, abjuring monetary power can equally be a source of leverage as long as market forces cause comparable costs for country B and equally strong incentives to change its economic policy in a direction that is in the interest of country A. The US can use the monetary tool actively (e.g. “talking down the dollar”) or passively (e.g. “benign neglect” or “it’s our currency, but your problem”). This has been called the ‘dollar weapon’ (Henning 2005). This has proven fairly effective in the past, especially when combined with threatening to limit market access (Destler & Henning 1989). More recently, it has been less effective as target countries have become better at deflecting pressure (e.g. sterilised FX intervention in China). Ultimately it is country B’s greater dependence on country A’s market that makes the dollar a potent instrument of economic statecraft.
Last but not least, instead of threatening to impose costs, economic statecraft can offer benefits to target countries. Such measures can simply be the reverse of negative economic statecraft. Country can simply offer country B greater market goods and financial market access. It can also offer to provide official loans or provide support for private-sector loans to country B. In the context of the multilateral trade regime, this can be done through free-trade agreements, less so through bilateral investment treaties. In the case of the US, lending can be offered bilaterally through USAID, Ex-Im Bank or, more recently, Overseas Private Investment Corporation. Or it can be offered multilaterally through institutions such as the IMF, the World Bank and regional development banks where the United States is the most important or an important shareholder. Once a loan has been extended, asymmetric dependence has been established. This is because the recipient country is relatively more dependent on financial support than the US depends on the repayment of the credit. Similarly, a default will have greater negative consequences for the recipient country than for the US.
By and large, economic power emanates from inequality of size, related “asymmetric interdependence” and control of over strategic - be they strategic commodities (like technology) or public goods (like the dollar). This is so because the economic costs of the use of the tools of economic statecraft needs to be relatively less significant for the sender country than for the receiver country in order for it to be a credible tool. To the extent, however, that economically powerful country A takes advantage of its superior position to exploit target country B’s sensitivity and vulnerability, country B will (over time) seek to reduce either the asymmetry or the interdependence (or both). It is typically economically and financially costly to reduce interdependence, and sometimes there simply aren’t any alternatives available, at least not in the short run (e.g. US high-tech goods). Much depends on how aggressively and how frequently country A exploits asymmetric interdependence. The existence of third parties can limit or mitigate the nefarious effects of negative economic statecraft on target country B.
In the case of commercial and financial sanctions, third-party enforcement is often necessary for sanctions to have the intended effect. Preventing a foreign country from purchasing US semi-conductors, for example, will only cause costs and no benefits if there is a price-competitive near-substitute available to the target country. Closing the market to the target country will not be particularly effective if the target country can send its export elsewhere. The same applies to the effectiveness of financial statecraft. Sometimes third countries will purposefully seek to provide support (so-called black knight) at non-negligible cost to themselves in order to buffer the impact of sanctions on the target country (Early 2015). More often, third countries (and companies) will simply take advantage of the target country’s economic policy and replace the sender country as an economic partner (Drezner 2011, Early 2009, Farrell & Newman 2019). This is precisely why extra-territorial, secondary sanctions are important and often so difficult to implement effectively. Coaxing allies into supporting specific sanctions may be difficult. Coaxing geo-political adversaries into supporting sanctions is typically well-nigh impossible. This is one of the reasons why sanctions often fail in terms of their intended objective, but also why they are more successful against geo-political allies than adversaries, though there are exceptions (Hufbauer et al. 2009).
The evidence suggests that US sanction policies are at best moderately effective (Hufbauer et al. 2009). In less than half of all cases are they successful in terms of realising their intended foreign and security-related policy objectives. By contrast, US economic power when directed against economic partners for economic rather than political or security-related ends appears to be far more successful – at least judging by the following list of high-profile, non-random examples. If empirically, this would not be surprising. If states are adversaries in the security realm, they will view themselves as playing a zero-sum games. The target state is likely to have a higher pain threshold and it is less likely to give in to the sender country's pressure. Within alliances the security externalities of will not be a very relevant factor when it comes to economic conflict and economic statecraft. It is easier for the target state to make concessions to the sender state given the broader security relationship. Another way of putting is to say that 'high politics' (security) beats 'low politics' (economics). So if the definition of economic statecraft is modified to include the use of economic instruments in pursuit of economic (and not just foreign policy and security related) objectives, then economic statecraft can be hypothesized to be much more effective. The arbitrary list below shows that US economic statecraft (broader definition) is less effective when targeting actual or potential geo-political adversaries and more effective when targeting geo-political allies. The nature of the objective and the nature of the security relationship between sender and target state seems to matter.
In view of Japan’s expansion in China and South-East Asia, FDR gradually tightened trade and financial sanctions in order to prevent Japan from acquiring strategically important goods necessary to support Tokyo’s war effort (primarily: export controls of strategic commodities). What exactly FDR’s diplomatic objective was (deter Tokyo or provoke it attack US interests in Asia) continues to be debated by historians (Utley 2005, Trachtenberg 2006).
In an attempt to stop the drain on US gold reserves and regain economic policy autonomy, the Nixon administration effectively dismantled the Bretton Woods system, devalued the dollar against gold and slapped an across-the-board tariff on imports (Odell 1982, Gowa 1983). Market access restrictions in the form of tariffs forced the other major economic powers to come to the negotiation table and agree to a revaluation of their currencies in the Smithsonian agreement.
Following the developing countries’ debt crisis of the early 1980s, the US put pressure on the other major economic powers to agree to higher capital requirements for internationally operating banks (Kapstein 1989). The US threatened to exclude banks headquartered in countries that did not sign up to the so-called Basel Accord from doing business in the US (threat of financial market exclusion). All major countries signed up.
During the 1980s, the Reagan administration used the (implicit) threat of protectionism to nudge the other major economic powers to agree to exchange rate and macroeconomic policy coordination, first in the Plaza Agreement (1982) and then in the Louvre Accord (1985). The threat of trade restrictions and the use of the dollar weapon led the other major countries to agree to greater coordination (Funabashi 1989).
The Bush Sr. administration used protectionist threats (market exclusion) to coerce Japan into granting the US greater market access and accepted so-called “voluntary export restraint”. A classic case of exploiting a smaller country’s trade (and security) dependence.
Under the present US administration, the threat of more restricted market access led Japan, Korea, Mexico, Canada to agree to ‘mini-deals’ and make concessions demanded by the US.
The Trump administration has also sought to exploit asymmetric interdependence with regard to China. Given security externalities and less skewed interdependence, China held out longer but finally made concessions. It is notable that Washington is mobilising (or has considered mobilising) virtually all sources of US international economic power to go after China near-simultaneously. Here is a non-exhaustive list: tariffs, restricting Chinese FDI, redirecting US investment away from China, threatening to ban or de-list Chinese companies from US financial markets, export controls etc. It has even considered FX counter-invention and a selective default on US government debt held by China (not seriously, one hopes), branded China a currency manipulator (Jaeger 2019). And Washington is trying counter US influence in third countries by through OPIC. One thing it has not done is launch free-trade agreements to pull other economies closer into its orbit. As a matter of fact, one of the first acts of the incoming administration was to abandon TTIP.
Economic statecraft will remain highly relevant and the diplomatic instrument of choice as Sino-US competition intensifies and international economic relations become more politicized (Jaeger 2019, Jaeger 2020). It is more important than ever to understand the sources and uses of economic power and the effectiveness of economic statecraft.