Economic and Political Power in International Affairs - A Partial Framework (2024)

Economic size, economic power and international influence are correlated. The United States and China do not only have the largest economies, they are also the largest military spenders. Typically a function of its economic size, the level of military spending a country can afford is only one aspect of its international power. The ability to impose costs or confer benefits on other country by intervening in cross-border trade and financial transaction is another important aspect of a country’s international power.

Economic size, resource mobilization and international economic power

Economic size confers a country the ability to mobilize resources in support of its foreign policy objectives. The size of an economy is a good proxy of its resource availability. An important caveat is that high per capita countries have, all other things equal, a greater ability to extract resource before domestic consumption falls below sustainable or even subsistence levels. A country with a low level of per capita income cannot extract more resources than a country with a high level of per capita income, all other equal.

Economic mobilize-ability refers to the share of economic output that can be dedicated to the pursuit of foreign policy objectives on a sustainable basis over a given time horizon without jeopardising economic stability. Political mobilize-ability refers to a government’s ability to mobilize resources over potential domestic opposition. It stands to reason that less democratic regimes may face fewer political constraints in this respect than democratic ones. The Russia-Ukraine war and the uncertainty about the willingness of Western countries to support Ukraine is a case in point. On the other hand, history also suggests that in the face of major, as opposed to minor geopolitical threats, and particularly in the context of an armed conflict, democracies are quite capable to mobilizing huge amounts of resources in pursuit of their foreign policy objectives. The ramp-up of defense production and the reduction of private consumption following the U.S. entry into World War suggests as much. The US fiscal deficit reached 30% of GDP in 1943.

Broad geopolitical influence is in part a function of a country’s ability to spend more than its antagonists. Over the long run, differences in real GDP growth will impact economic size and relative resource availability. However, an economy that is characterized by a low level of per capita income and small population size would need to grow significantly faster over an extended period of time to narrow the difference vis-à-vis a much larger and richer country. Even if Luxembourg grows twice as fast as Germany, the relative resource availability will not be significantly changed twenty years from now.

Governments can mobilize additional resources domestically or internationally. Domestically, they can do so by relying on rapid economic growth, raising taxes and cutting expenditure unrelated to its foreign policy objectives, or by running a larger fiscal deficit. Governments can also raise resources externally through issuing debt or receiving financial support from other countries. In the long term, however, countries will generally run into constraints if they rely on domestic or external borrowing rather than their own resources over an extended timeframe. 

In practical terms, the United States will always spend more resources on defense and foreign policy than an economically much smaller economy like Mexico. However, this is less likely to be true when comparing Chinese and US defense expenditure, for example. China is growing more rapidly than the United States and it has room to increase defense expenditure, which is far lower as a share of GDP than in the United States. The point is that in the case of economically similar-sized geopolitical competitors, differential growth rates do matter, at least over the longer term. 

In addition to economic resources and the ability of governments to extract resources in support of a country’s foreign policy objectives, its ability to intervene in the cross-border exchange of goods, services, capital, technology and data is also an important source of geopolitically relevant economic power.

Economic interdependence and international economic power

A high level of economic interdependence provides countries with opportunities to take advantage of interdependence and exploit economic-financial vulnerabilities by imposing or threatening to impose economic costs or conferring or promising to confer benefits on another country. This works best when interdependence is asymmetric and the target country finds it difficult side-step the costs of adversarial measures. 

First, a country’s ability to restrict cross-border trade has the ability to impose costs on another country. Imposing tariffs on imports leads to lower exports and lower economic growth. While it also translates into economic costs in the country imposing tariffs, the costs to the target country are far greater if the relationship is asymmetric. If U.S. tariffs make it more difficult for China to exports goods to the United States, its economic growth will suffer. 

Second, countries can also impose export controls, often prohibiting the sale of specific goods to specific countries. This can to significant economic disruption in the target country. The United can restrict the export of advanced semi-conductors to China, while China can restrict the export of rare earths. Countries ability to impose costs, and thereby potentially exercise influence, is significantly enhanced if restricted goods cannot be easily, or at all, replaced, increasing the opportunity costs of supply. Arab oil producer embargo massively increased prices and imposed significant costs on advanced economies in the context of the Yom-Kippur War of 1973.

Third, a country, or rather a government, can offer or withhold financing to another country. To the extent that nobody else may be willing to extend financing, for example during a financial crisis, at sufficiently attractive terms, the sender country may be able to exercise power, not least by withholding financing. Moreover, some countries, like the United States, have significant institutional leverage due to their prominent position in international financial institutions, like the International Monetary Fund or the World Bank. In Europe, the larger euro area members can exercise power by vetoing the extension of credit to crisis-ridden members in the context of the euro area architecture created in the wake of the euro area financial crisis 15 years ago.

Fourth, with the help of inward investment restrictions, governments can exclude companies from specific countries to buy certain types of companies. This often serves as a way of restricting other countries’ access to technology and intellectual property rights and can help weaken the longer-term development prospect of countries. Similarly, outbound investment restrictions, most recently introduced by the United States, have a similar objective of limiting technology leakage to companies in other countries, in this case China.

Economic interdependence, sanctions and risk mitigation

Influence and susceptibility to influence is a function of the relative of the target country’s dependence on the sender country with respect to a specific type of cross-border flows. How vulnerable a country is depends on the opportunity costs of neutralizing adversarial measures. In the case of sanctions, for example, third-party spoilers and black knights, whose intervention is motivated by economic gain and geopolitical interests, respectively, can help limit the opportunity costs. This is why enforcement vis-à-vis third parties is often key, as Western policymakers have begun to find out when it comes to imposing economic costs on Russia.

What can countries vulnerable to, for example, trade restrictions do to mitigate risks? Answer: Reshoring, friend-shoring and diversifying. Reshoring is typically costly, as production and supply chains are moved from low-cost countries to higher-cost places. Reshoring as such may reduce international vulnerability, provided no critical part of the supply chain is left vulnerable, but a higher geographic concentration of production may increase risks if domestic production is negatively impacted by shocks. Friend-shoring tends to be less costly than reshoring. Finally, diversification is also costly, as companies need to put in place more diversified supply chains but redundancy helps with risks. But it typically offers the best trade-off between risk reduction and costs.

Are sanction efficacious then? Leaving aside third-party spoilers and black knights, the academic research suggests that economic and financial sanctions in the sense of changing another country’s behaviour are rarely successful in the case of targeting a geopolitical adversary. Sanctions are more successful in case of geopolitical allies. This can be rationalized by the closer economic relations between allies and the higher costs sanctions cause, and also by the likely lower geopolitical stakes given the target and sender countries geopolitical proximity. Similarly, in case of geopolitically adversarial countries, a less extensive economic relationship typically means that sanctions lead to lower costs in the target country, while the political stakes are necessarily higher. This does not mean that sanctions never work in terms of changing an adversary’s behaviour (e.g. US-Iran), but it is relatively rarer. Again, Western sanctions targeting Russia are a case in point. This does not mean that sanction cannot be or are no t effective in terms of imposing economic costs, signalling (domestic and international), deterrence or degrading a target country’s economic base. But they rarely lead to a change in desired behaviour.

The varieties of international economic power

Broad international power and influence is to a large extent a function of a country’s ability to mobilize resources. It is also a function of a country’s ability to exploit asymmetric interdependence by restricting or supporting the cross-border flow of goods, services, capital and technology. Economic size matter, but it is not the only thing that matters in terms of exercising power in international politics. A stable economy, limit vulnerability and solid long-term growth prospect combined with a significant overt or latent ability to mobilize economic resources and convert them into diplomatic or military power. Asymmetric economic and financial relationships and another country’s limited ability to offset cost-imposing measures by forging close economic and financial relations with a third country are another important source of power international politics.

Why Europe Has Made Little Progress on Banking Union (2024)

Europe’s banking union remains incomplete and the prospect of significant progress toward closer integration, particularly with respect to a common deposit insurance scheme, remains unlikely, as creditor countries are unwilling to indirectly backstop debtor countries’ sovereigns. The euro area sovereign and financial crisis which started almost exactly fifteen years ago led European policymakers to the realization that Europe’s fragmented banking supervision regime, largely under the purview of national authorities, required significant strengthening. Economic and Monetary Union (EMU) had been intentionally designed in such a way as to force members to take responsibility for their own financial stability by prohibiting individual members from assuming the financial liabilities of others. In the face of the financial crisis late noughties, however, the absence of an overarching financial architecture capable of pre-empting a systemic financial crisis due to the so-called sovereign-bank nexus. In some instances, sovereign distress and default caused banking sector instability (Greece, Italy, Portugal). In others banking sector weakness led to sovereign financial distress (Cyprus, Ireland, Spain). Without the ability to intervene and backstop sovereigns and national banking sectors, this nexus risked turning into a self-reinforcing financial doom loop. In response to the Greek financial crisis, the euro area created financial instruments and a financial architecture to deal with financial instability by providing distressed countries with financial support in the form of loans issued to government. In the face of the Spanish banking crisis, Europeans then proceeded to consider the public, joint and direct recapitalisation of banks through the European Stability Mechanism, which originally was meant to provide loans to governments only. With a fiscal union not on the agenda due to creditor country opposition and a desire to sever the sovereign-bank nexus, banking sector union represented a second-best solution. The reform of the euro financial architecture, including the move towards banking union, allowed ECB President Mario Draghi to give his “whatever it takes pledge” in the summer of 2012, which effectively saved the euro area from a financial meltdown and potential breakup. 

> Pre-crisis, there existed only limited harmonisation of banking regulation, but only in the form of directives rather than regulations, such as the Banking Directive (2000) and the Capital Requirements Directive (2006). National authorities remained in charge of supervision. The EU also created a Committee of European Banking Supervisors (CEBS) in 2004.

> The Maastricht Treaty contains an enabling clause that allowed the ECB to take on prudential supervision of credit institutions and other financial institution, subject to Council approval and EU Parliament assent. This article formed the legal for the euro area members to establish a banking union and delegate supervision to the ECB.

> In 2012, the Van Rompuy proposed the establishment of a banking union, a fiscal union, an economic union and a political union to strengthen EMU and the EU. Banking union presented the path of least political resistance.

Banking union, as originally envisioned, was to consist of three pillars – supervision, resolution and common bank deposit insurance – but euro area governments only succeeded in establishing the first two. Rather than a politically impossible to achieve fiscal union to sever the bank-sovereign nexus, euro area governments agreed to move towards a banking union by establishing euro area level banking supervision and a resolution authority (including a resolution fund) to reduce the risk of destabilizing financial spill-overs by preventing bank failures from triggering sovereign distress and preventing sovereign distress from destabilizing the national and European banking sectors. The Single Supervisory Mechanism (SSM) entered into force in 2014 and transferred the supervision of larger euro area banks from the national supervisory authorities to the European Central Bank. Smaller and mid-sized remained under the supervision of the national authorities, but the ECB was given authority to intervene in them in case of a risk to systemic financial stability. The Single Resolution Mechanism (SRM), consisting of a Single Resolution Board (SRB) and Single Resolution Fund (SRF), transferred the authority to intervene in and, if necessary, resolve in an orderly fashion euro area banks to the body. But euro area governments failed to create a common European deposit insurance regime and a common backstop supporting the SRF. Instead, they issued a political declaration that a common backstop would be created to strengthen SRF within the next ten years. Meanwhile, member states would ensure that national deposit insurance schemes would accumulate sufficient funds to cover 1% of their deposits by end-2023, which would then be fully mutualized to support the SRF. 

> All twenty euro area members are members of the SSM. Non-euro area members have the option to participate in the regime.

> The SRF is financed by contributions from banks. A reform was meant to create a common public, if limited financial backstop to the SRF in the guise of a ESM revolving credit line of nearly EUR 70 billion in case SRF resources are insufficient to finance a resolution. This reform has been stalled due to Rome’s unwillingness to ratify ESM treaty change.

> The SRF is not meant to be used to absorb financial losses incurred by a distressed bank or to recapitalize it. Under certain circumstances, the SRF can provide substantial support to a bank under resolution, but only if at least 8% of the bank’s total liabilities have been bailed in and contribution must not exceed 5% of the bank’s total liabilities.

Efforts to establish a common European Deposit Insurance Scheme (EDIS) to guarantee euro banking sector deposits has not made any substantial progress, largely due to opposition from creditor countries like Germany, while the creation of common ESM-backed backstop to SRF has been blocked by the Italian government. As it stands, the SFR has only limited funds to deal with a systemic banking crisis. But creditor countries not willing to make a pledge to guarantee banking sector deposits in the guise of EDIS for fear of indirectly underwriting debtor countries banking sectors and sovereigns. Instead, Germany has pushed for higher capital charges on bank holdings of sovereign debt to reflect their inherent risk. Such concentration charges would reduce the risks to (debtor) countries’ banking sectors. This however is unacceptable to debtor countries, as they rely on their banking sector to provide financing, particularly during a crisis, and if necessary through moral suasion. The so-called regulatory treatment of sovereign exposures (RTSE) is a non-starter for debtor countries, while it is the starting point for creditor countries if they are ever to agree EDIS. Without progress on RTSE, creditor countries are not going to back a European deposit insurance regime, as they are concerned about indirectly risk insuring other countries’ sovereign risk. Meanwhile, the establishment of a (limited) common backstop to the SRF failed due to Italy’s failure to ratify the necessary ESM treaty change. Making further strides toward a more complete banking union will require euro area governments to find a compromise on how to deal with sovereign exposures and how to share the financial risks related to EDIS. The present relative stability of euro area banking sectors, which have managed to make it through the global monetary tightening relatively unscathed compared to some of its American peers, sharply limits the incentives to reach an agreement. It will require another major crisis for substantial progress to occur. 

> The SRF common backstop was meant to replace the so-called (unwieldly) Direct Bank Recapitalization Instrument. Italy continues to block changes to the ESM and has prevented the common backstop from entering into force. We need to send somebody to Rome to find out why the government opposes ratification. The we did not like the way we were treated a decade ago explanation does not strike one as a plausible explanation.

> The von der Leyen EU Commission failed to establish, or make progress toward a European deposit insurance scheme and create a common backstop to the SRF, despite its pledge to do so when it came to office in 2019. This shows just far apart creditors and debtors are on the issue of completing banking union.

 

Argentina - Evaluating the Short- And Long-Term Economic Outlook (2024)

With the election of Milei and the dramatic change in economic policy, the outlook for medium-term economic and financial stabilization has improved dramatically; but absent political-institutional reform, the risk of a return to instability will increase over the long term, largely due to the political system’s inability to manage fiscal-distributional conflict. Under Fernandez (2019-23), pre-electoral spending splurge risked pushing the economy into hyperinflation and a failure to adjust its external financial position, following the 2020 debt restructuring. With the election of Milei, Argentinian economic policy underwent radical change. A reform program anchored on a massive fiscal adjustment has received support from the IMF program and has led to a sharp of inflation, an improving government and external debt position, while also reading to a sharp drop in economic activity. The government has made extensive use of its decree power to push through reform due to a lack of congressional support. If the government persists in following IMF-guided policy adjustment, which is likely, the economy will recover in the context of much reduced inflation by 2027, boosting Milei’s reelection prospects. 

> The IMF projects real GDP growth of 4% and inflation of less than 20% by 2027, a substantial decline from the triple-digit rates in the past few years.

> President Milei has only limited support in Congress, complicating structural, less so macroeconomic economic reform. The Ley bases, which comprises far-reaching market and liberalization structural reforms, was passed by the lower house in April and expected to be approved by the Senate.

Since taking office, Milei has made solid progress towards putting the economy on a more solid footing. A massive fiscal adjustment has allowed the government to generate primary fiscal and overall surpluses. It has also allowed it to stop the inflationary monetary financing of the government, deficit be the central bank as well as improving the profile of domestic debt, including domestic debt swap to reduce roll-over risk. On the external debt side, Argentina has received financing assurances from multilateral lenders and, crucially, China, pledging to roll over portion of PBOC swap not drawn. External surpluses have helped improve the central bank’s financial position. Fiscal and current account surpluses have allowed the authorities to refrain from further monetary financing and the BCRA to strengthen its balance sheet and improve its FX reserve position, even though not negative anymore remain inadequate. 

> IMF successfully concluded eight review under current program in June. Argentina exceeded all quantitative performance criteria with a significant margin and progress on structural benchmarks.

> The IMF expects (hopes) that the government will be able to access international capital markets by the end of 2025. As long as Argentina overdelivers on program targets, the IMF will continue to provide support, thus limiting financial risks.

The economic and financial (reform) outlook will remain challenging. First, while parts of the economy seem to have stabilized, a prolonged economic downturn could weaken the president’s popularity and embolden political opposition, which would lead to a worsening of the reform outlook. Second, further fiscal consolidation to make sustainable. Following the massive fiscal adjustment by presidential decree, the governments needs to lay the foundation for institutionalized fiscal stability by extensive expenditure and revenue reform. Third, the removal of capital controls and the liberalization of the exchange rate are key to reviving international investor interest in Argentina. MCP and exchange restrictions remains in place hindering resource allocation etc. The establishment of an inflation-targeting monetary and flexible exchange rate regime, including MCR and exchange restrictions, is highly desirable to strengthen stability. This will require higher domestic interest rates to create sufficient incentives to get residents to hold pesos. But real interest rates remain in negative territory. The government has pledged to moving toward a liberal foreign-exchange and capital account regime, but this will require higher interest and could in the short term increase inflation, and might thus weigh on the president’s popularity. A failure to pass could lead to renewed domestic political conflict with the president taking more forceful action without necessary political or social support, which could reignite social dissatisfaction, even unrest.

> IMF favors improving the quality of fiscal adjustment and establishment of a monetary and exchange rate regime as well as structural reform aimed at lifting economic growth and productivity/investment and employment

> External surpluses required to re-access international capital markets and generate sufficient liquidity to repay its maturing obligations including IMF loans.

> The government has taken some steps towards greater currency liberalization, but it is far from liberal

The short-term economic and financial outlook is manageable, but it there is little reason to believe that Argentina is in the process of overcoming its long-term susceptibility to recurrent economic instability and financial crises. Argentina has experienced recurrent economic instability and financial crisis. Most recently, Argentina defaulted on its foreign obligations in 2001, 2016 and 2020. While the long history of defaults suggests that defaults happen under differing political regimes, a comparison with more successful and lasting economic stabilization in other Latin America economies suggests that Argentina may yet again fall short of establishing long-lasting economic stability. Chile, Mexico and Brazil have not experienced major destabilization in the past few decades, let alone an external debt restructuring. The countries brought about economic-institutional change without fundamentally changing the political system or constitution. Floating exchange rate, independent and inflation-targeting central bank and commitment to fiscal discipline. Fiscal dominance and political conflict over fiscal and secondarily interest rates. But in Brazil, fragmentation of political system difficult to reverse reform, even though under Lula/ Dilma lack of respect for rules can lead to trouble, but enough checks-and-balances and robust institutions. In Mexico, this will be challenged given MORENA dominance and in view of proposed constitutional reform. Institutional reform necessary to boost long-term confidence and sustainability of reform. Argentina has a history of fiscal dominance, whereby a high-spending government forces the central bank into monetary financing of its deficit in the context of tightening foreign and exchange controls. Distributional politics and government ability to solve distributional issues through higher, if inflationary government spending.

> The last time, Brazil or Mexico defaulted on their foreign obligations was during the so-called Latin American debt crisis of the early 1980s. The last time Brazil and Mexico IMF adjustment program to avoid a broader systemic financial crisis in was in the early 2000s and mid-1990s, respectively.

> Both Brazil and Mexico underwent important reforms of their policy regimes, including the establishment of an independent, inflation-targeting central bank, a flexible exchange rate regime and a political or institutional (even constitutional) commitment to fiscal discipline. This has helped both economies absorb severe exogenous shocks, such as the dotcom bust, the global financial crisis and COVID-19.

> By contrast, Argentina restructured its foreign debt in 2020, following a major default in 2001 and a selective default in 2016. Ironically, Argentina is a major international creditor with household holdings of foreign assets far exceeding public external liabilities. If Argentina managed to convince Argentines that economic and financial stability is here to stay, it could benefit from massive capital reflows.