This post is a response to a long email debate on the decline of America that started off with the following article sent to a small group:  

America the Miserable
http://www.spectator.co.uk/essays/all/5719098/america-the-miserable.thtml

(warning - this post cites from the one immediately prior)

I'll throw in a few cents - I just came back from a [...] seminar with [...] a small group of smart people, and the general perspective in the discussion was that we have much more to worry about than the decline of America.  If you tack on 'relative to other nations,' this is inevitable, I think, given America's undisputed hegemony since WWII.  We're not as hungry as China or India, who now have nearly unfettered access to networks of exchange compared to half a century ago, and no amount of speeches will make us so.  But America declining in absolute terms doesn't seem to be a real concern in the near future.  
 
More worrisome is a set of macro dynamics which include an increasingly unstable financial nonequilibrium ( i.e. US deficits financed by China), growing China influence over Asia-Pacific and Africa, declining power by any single entity to control outcomes, growing inequality between the haves and have-nots, development of nuclear weapons by non-democracies, potential for state-sanctioned cyberwars in an era where nearly all systems including battleships are networked, increased power of individual and non-state actors, and uncontrollable and accelerating knowledge flows – creating massive uncertainty and the potential for catastrophic outcomes.  We should be deeply and viscerally afraid.

I agree with C. in his call for pragmatism and the avoidance of what N. calls "wishful non-thinking," but I also agree with M.'s call for an action orientation.  The striking thing about old frameworks is that they tended to neglect the power of the observer-actor, which historically was, well, negligible.  In a very real way, and because of the advances in the digital infrastructure, this is no longer the case.  Though it's becoming increasingly hard to control outcomes, we can change them.  Sitting here in London, I'm struck by the differences between the US and other countries in implied degrees-of-freedom to act that can be imputed from behavior - I'm probably being opaque, but people outside the US seem to act in a more bounded way than Americans (with different bounds for different nations). That's an enormous cultural advantage in an environment where individuals and non-state actors have more power. Being here, I'm also struck by the relatively stable unwinding of the massive British empire over the last century, leaving the UK still a significant player on the world stage. We would do well in the US to consider how to manage the inevitable devolution of power in a stable and strategic way. Decline of nation power doesn't necessarily need to mean decline of the power of our values.

I just returned from several days at a seminar on the current state of the world and what the future holds.  I thought I’d share what I learned from everyone intermixed with some of my own thoughts.  Warning, this is quite long.

The World Is Always More Complex Than We Think

It was an extraordinary gathering of 20 brilliant individuals and my very-average self, from a breadth of expertise that included finance, economics, business, energy, history, and specific markets such as China, India, Argentina and Africa.  They included presidents and vice-presidents, founders and CEOs, principals and partners, professors and PhDs, and philanthropists.  

What struck me, however, was that not a single person there had a truly comprehensive grasp of all the issues that confront the world today.  Almost two years after the start of the financial crisis, there are relatively few people even in senior positions in finance who fully understand what happened.  There are no people who know what will happen.  I certainly don’t.

The interconnectedness of the world is such that small triggers in small nations can start a conflagration.  A great analogy was drawn in the seminar to the dawn of World War I and the assassination of Archduke Ferdinand, the heir to Austria-Hungary, by Serbian nationalists.  There are a number of possible equivalents today.  For instance, Iranian nuclear weapons development would demand military action on the part of Israel, which lacks the capacity to target the facilities with the precision needed to avoid massive civilian casualties.  If the Israelis credibly commit to taking action nevertheless, the United States, Israel’s ally and the only nation with such ability, could then be drawn into a war that has the potential to draw China in on the opposing side to protect its Iranian interests.  Stranger things have happened, and this is just one of many equally frightening scenarios.  

Beware “Wishful Non-Thinking”

We tend to avoid thoughts of scenarios that frighten us.  We prefer to think of the world in terms of steady progress, advancing technology, improving quality of life, and increasingly stable relationships with other nations who share our world.  Unfortunately, this is not always and everywhere true.  Macro dynamics -- which include an increasingly unstable financial equilibrium ( i.e. US deficits financed by China), growing China influence over Asia-Pacific and Africa, declining US power on a relative basis, growing inequality between the haves and have-nots, development of nuclear weapons by non-democracies, potential for state-sanctioned cyberwars in an era where nearly all systems including battleships are networked, increased power of non-state actors, and uncontrollable and accelerating knowledge flows – are creating massive uncertainty and the potential for catastrophic outcomes.  We should be deeply and viscerally afraid.

Though someone might argue that perhaps we should not speak of these things for fear of self-fulfillment, the objective is to prevent catastrophic outcomes by recognizing their possibility and the risks we face when we undertake a course of action – as well as the release valves.

What Can We Know About the Future?

The short answer is – not much.  We do know a few things from the lessons of the past.  First, that a global economy can take decades to build and a week to destroy.  We also should not forget that sovereign powers will generally always do what is in their own best interests, including the United States, and that diplomatic relations between sovereign powers can be fragile.  We should not forget this in the warm glow of making friends from all over the world.  Individuals and groups of elites will generally always do what is in their own best interests as well.  Sometimes the interests of nations and individuals diverge.  When they do, closer interests almost always win over national interests, as in the case of the waning power of German Prussian elites in the age of industrialization leading up to World War I.  Unfortunately, foreign policy aggression has historically been a proven method of gaining legitimacy with constituents.   

We also learn that we have to take a whole-system view, not one that is narrow or discipline-based.  If we think of the world solely in terms of economics or geopolitics or development or climate change or technology or the Western world, we will not just be wrong, we will be very, very -- and potentially catastrophically -- wrong.  It’s easy to talk up the Internet but the advances in social media might be moot if we engage in a massive cyber-war with another nation-state.

The global financial system is also not out of the depression woods yet.  Greece has shown us that.  High unemployment, several key countries still teetering on a deficit and debt brink, continued conflict and the possibility of other stages of action create a tinder pile that can be lit up at any moment.  No one anticipated World War I before it started.  Keep in mind as well that few (or none) of the causes of the financial crisis[i] – leverage, ratings abuse, low Fed funds rate, financial insurance[ii], home ownership rate[iii], and high Chinese savings  -- have been or will be mitigated by the proposed solutions (e.g. Volcker rule[iv]).

We should be careful, however, about drawing historical analogies.  We don’t have very much recorded history to draw from, and the differences between the causes of two vastly different scenarios can be trivial and arbitrary.  The world today is in many ways very different from all the worlds of yesterday – in technology, the deep levels of global interconnectedness, presence of nuclear weapons, power of individuals and non-state actors, labor mobility, international integration of institutions, and so on.  It is the lessons from the underlying drivers that we should absorb, the lessons of psychology and geopolitical strategy.  

China’s Situation

We should consider this as we ponder the growing influence of China and the key drivers of their behavior – internal political stability, economic growth, a stable currency, and minimizing financial risk (roughly in that order).  Indeed, we could narrow this list of drivers to the first item.  Political stability rules the roost, and at the end of the day, GDP growth is a political number to the Chinese.  Their actions and response to Google in China make perfect sense in this light.  

China is sitting on a powder keg itself.  It has been enormously successful in modernization using a command-and-control approach to the economy.  It has come at the cost, however, of purchasing enormous amounts of US currency and dollar-denominated debt in order to keep the RMB devalued, as well as censorship and high degree of political control.  If they were to float their currency, it would increase price levels by an estimated 30% and cut GDP growth in half, an untenable outcome from a political standpoint.  Gentle appreciation will be the new policy but their currency will remain devalued for some time to come.

Their economists, however, are recognizing the risks associated with holding as many US dollars as they are.  They are moving to deploy these dollars to purchase commodities assets, such as copper mines and oil fields, typically in other emerging markets such as in Africa.  These commodities not only represent an excellent investment, they also feed into China’s growing production.  American commodities companies will never be able to compete in a bidding war with China, given that they are not able to take advantage of some of the less savory negotiation strategies.  More importantly, with China’s interests expanding to cover some of the most remote nations, this mean the rest of world is in play.

Though the China-America relationship is one of co-dependence, it is possible that China will, to an increasing degree, find American dollars to be less attractive in general.  Their ability to manage quite well through a sharp downturn in exports might signal an awareness that the American relationship might not quite be so critical to their national well-being as previously thought.  They also have the ability to manage decreased exports through the installation of a social safety net, a noted method for decreasing savings rates and increasing domestic consumption.  This does not bode well for geopolitical stability, especially as China begins to face unrest related to its high degree of political control.  Remember that foreign policy aggression is a tried-and-true method for boosting legitimacy among constituents.

China vs. India (vs. US)

At first glance, it might look like China, with its growing influence as world creditor and seeming ability to manage its way out of any undesirable circumstances using its abundance of savings, is indisputably going to be the United States of this century.  It is attracting enormous inflows of capital and growing consistently in the 8 to 10% range.  Its sphere of influence is expanding across the globe.  To many intelligent investors, China is a far more attractive place to invest than either the US or India.  An analysis by Goldman Sachs projects China’s GDP to exceed the US by 2026 (with India surpassing the US a few decades later).  This is in our lifetimes.

However, the only thing we know for sure about these projections is that they are wrong.  No one knows enough to project out that far.  As we have seen in recent years, forecasting models have assumptions and those assumptions are often wrong.  The assumptions for a 16-year projection are definitely wrong. 

But that shouldn’t keep us from doing the thought experiment about what lies ahead.  Given current states and trajectories, there are only three main contenders for the role of economic superpower (Russia being a petrostate, Brazil being the permanent “next big thing,” and the EU facing issues of growth and unity):  China, India and the US.

We’ve made the argument for China.  Let’s see if we can make it for India.

Imagine the world that (likely) lies ahead in the next 20 years, assuming we don’t fall off a nuclear cliff somewhere in-between.  The digital infrastructure is yielding the promised productivity gains as the technology seeps slowly into the enterprise.  Norms around digital regulation have been largely established, including a public-private compromise around intellectual property rights.  Broadband access is widespread and broadly accessible in the developed world and in many parts of what we call the developing world today.  A remarkable proportion of global GDP is either services or the knowledge component of tangible products.  China is still the scale manufacturer for the world but is slowly shifting away from a command-and-control economy, while attempting to manage civil unrest and growing vocal demands for elected representation.  Meanwhile, India has a growing knowledge economy with a vibrant entrepreneurial sector, a more cohesive democracy, and the rule of law (though it still struggles with the slow civil bureaucracy).  Its knowledge workers, however, are almost as productive as Americans as a result of ongoing interaction with English-speaking Western counterparts (I’ve seen this firsthand during my time in Hyderabad).  Both China and India have a sizable and well-educated middle class, though both have a number of citizens still living in poverty as well.  Much of the “catch-up” benefit from learning from developed nations has been captured.  The next waves of innovation will not come from a cut-and-paste replication from other nations.  Mostly, they will come from new products, breakthrough science, new processes, and new institutions.  The main driver of these innovations will be learning through access to global knowledge flows and the interconnections between people all over the world.  So, which is the country best able to compete in this environment, whose people have access to unfettered knowledge flows (i.e. no censorship), can speak the lingua franca of international business, and can retain its pool of educated and entrepreneurial talent through democratic representation? India.  

Though the question of India versus China is of enormous strategic interest, it is not particularly interesting from an investment standpoint.  Both India and China represent attractive markets for investment.  The question then is raised:  What is the right way to get exposure?  An interesting suggestion raised was to invest in US companies who are executing well in India and China.  Unbeknownst to many, about half of the revenue of S&P 500 companies in aggregate comes from outside the United States.  The key is to identify companies with significant exposure in these specific markets who have been successful in executing their strategies.

The  Future of the Bottom Billion

Despite the promise (and threat) of China and India, we should not forget that there are billions of people still mired in abject poverty, many living on a dollar a day and most of those in Africa.  Vast inequality is not only a moral issue; it is also an issue of geopolitical stability and long-run security.  We can go back in history and try to attribute cause – colonization, civil war, demographics, geography, population density, the resource curse, organized crime, corruption, economic aid, education, lack of governance institutions, health, nutrition, infant mortality, military intervention, and so on and so on.  Though it’s prohibitively challenging and perhaps well-nigh impossible to draw a true causal link, it’s worthwhile to discuss some of these factors.

Colonization gets much of the blame for the current woes of former colonies and client-states.  Whatever you might think of the illegitimacy of the colonizations of yesteryear, however, the data shows that long-term colonization, especially by the British, frequently resulted in significant quality-of-life improvements for the colonized.  Infrastructure, education, governance institutions and the English language are among the enduring legacies of the British empire.  India benefitted dramatically from these legacies after it attained independence and underwent economic reform.  On the flipside, however, short-term colonization, as well as empires managed by less responsible colonizers (e.g. Belgians), often disrupted development and resulted in lasting harm.  Some (Acemoglu, Johnson and Robinson in “Reversal of Fortune”) have argued that rich regions were readily exploited and tended to end up poor, while poor regions required colonizers to establish institutions in order to settle in these sparsely populated regions and ended up rich.

Environmental historians often attribute current poverty to historical conditions of geography – e.g. access to waterways for transport, availability of resources, uncultivable soil, low population density, weather conditions, natural barriers to trade, etc.  Though these theses may carry some truth, we believe in today’s modern world that they can largely be overcome.  

Organized crime and petty corruption are often viewed through the lens of culture.   However, if we look at these dimensions as economic phenomena, that is, informal systems driven by supply, demand and incentives, then possible solutions present themselves.  For instance, Misha Glenny in McMafia describe the origins of organized crime as the fulfillment of citizenry needs that the civil government was unable to meet, typically security, contract enforcement or commodities (illegal or heavily taxed).  Similarly, petty corruption is often the equivalent of a tax or fee for services rendered.  It tends to be not particularly obstructive to economic development unless it is unpredictable or paired with heavy-handed government control of market mechanisms.  We should note here that corruption is not just an issue in developing nations; regulatory capture in developed nations is also a form of corruption.

Civil war and violence are hugely disruptive to the economy, and are largely driven by demographics.  A disproportionate number of young males, combined with a multi-ethnic society (typically with one ethnicity outnumbering the rest), are the strongest predictors of civil war.  Poverty and civil war are closely interlinked, with the potential for a downward spiral.  Paul Collier has said that “half of all civil wars are postconflict relapses.”

Natural resources discovered too early in a nation’s life, before strong governance institutions have been developed, tend to be a curse.  The enormous and easy wealth contained in, say, oilfields encourages corruption and the rise of warlords, promotes exploitation by other nations, creates a mono-industry at the cost of labor-intensive export industries that might have emerged, results in a disconnect between leadership priorities and the needs of the citizenry (due to no taxation), funds military spending and conflicts, and provides disincentives for productive work.  To a lesser extent, there are some interesting (and controversial) parallels with certain types of foreign aid.  Foreign aid that is money given directly to a small set of individuals in power, without accountability, generates some of the same misalignments as an over-abundance of natural resources without proper governance.  Dambisa Moyo has argued that while “short, sharp and finite” aid interventions can help, open-ended systems of aid create faulty incentives.

Health, nutrition and infant mortality are all contributing factors to poverty as well.  Poor health and nutrition result in dramatically lower productivity, even with properly designed incentive systems for work.  Vast differences in heights, which turn out to be a good predictor of nutrition, are found between developed and developing nations (as well as between generations of citizens from a developing nation, once good nutrition is introduced).  In the poorest of countries, where there is low life expectancy, the savings rate tends to be low.  Development is well-nigh impossible with a near-zero savings rate.  High infant mortality, which we know creates incentives to have large families, paradoxically increases population growth.  Unfortunately, reduction in high infant mortality tends to cause a period of population explosion during which cultural norms for family size are being adjusted down.  Of course, this does not mean efforts should not be made to reduce infant mortality rates; rather, it is an argument that efforts should be conjoined with initiatives to promote education.

I tend to like Matt Ridley’s definition of poverty as durable and significant constraints on utilizing open networks of exchange, and therefore, low ability to reap the benefits of specialization.  In his words, if you have to make everything you need yourself, then you are by definition poor.  When you begin to think in terms of constraints around access and use of networks of exchange, it becomes clear that each nation-state merits its own diagnostic.  Poverty does not have a one-size-fits-all solution.  Some nations need health and education, others need formal governance institutions, some need a different kind of jobs-oriented foreign aid, a few need technology and physical infrastructure to overcome geographic challenges, still others may need military intervention to end a civil war (such as in Sierra Leone).  The question should be, what are the most serious constraints faced by the nation in utilizing networks of exchange.  Some of these constraints can be dealt with bottom-up, through aid organizations and direct to citizens.  Others, like certain governance structures, can only be instituted top-down.

Nearly all poor countries lack adequate governance structures.  They take time to build and require strong leadership, which make them difficult to install whole cloth.  However, they are critical to raising nations out of poverty.  Governance institutions make economic transactions possible in a low-trust environment.  They ensure that contracts are enforced, that property rights area upheld, the rule of law is to be trusted, and finally, that the fruits of work will accrue to the worker.  We mentioned previously that low life expectancy results in a low savings rate, which makes economic development almost impossible.  Insecure property rights, high inflation, and the threat of confiscation through arbitrary taxation also contribute to a near-zero savings rate in some countries.  Good political and monetary governance help build an environment where work and savings become attractive endeavors.

Governance, when executed well, generates a specific kind of trust.  Trust is the ability to extrapolate future patterns of behavior based on some body of evidence, typically historical patterns of behavior, signals or commitments.  In the case of good governance, the body of evidence takes the form of credible formal mechanisms for enforcement.  Interestingly, in high-trust environments, there is relatively low use of formal mechanisms.  Contracts, for instance, in the United States tend not to be prosecuted.  There is far more reliance on interpersonal relationships in high-trust environments rather than due process.   This suggests that governance structures are like the calcium skeleton required to uphold the overall structure, but the real work of an economy happens in the circulation in the flesh atop the skeleton.  Poor countries, which tend to be oriented around informal sub-networks of relationships in lieu of a general high-trust environment, are stuck in dysfunctional systems that work too well.  In these cases, a new and separate governance skeleton is demanded as the basis to build flesh on top of.  

The new flesh, or trust, needs to be grounded in three things:  1)  a shared sense of community, 2)  an understanding of shared gain, and 3) credibility derived through some body of evidence.  The first prerequisite is particularly pertinent in multiethnic societies.  We’ve seen before that certain multiethnic societies tend to be prone to conflict.  I propose that this conflict is likely due to low levels of trust, engendered by segregation and the resulting dysfunctional separate networks that promote corruption.  I don’t think it’s coincidence that the most corrupt cities in the United States – e.g. Chicago, Detroit, Buffalo, New Orleans, Newark, Youngstown (Ohio) – are also among the most segregated.  Next, education, particularly a grasp of economics, and clear communication of will help develop an understanding of the shared gain.  Finally, credibility is built over time through patterns of behavior first motivated by governance institutions.

How About Military Intervention?

If we pose the question to ourselves whether the United States should intervene militarily to install governance institutions for purely humanitarian reasons (as opposed to security reasons), there appears to be at least one cogent reason supporting this course of action.  The US military over the past decade and without too much fanfare has ridden a very steep learning curve and become very good at the business of nation-building.  Indeed, our soldiers are the experts in the world at this business, in addition to being the most experienced and well-trained soldiers in the world.  There is a high likelihood that we could be very effective in turning around some of the poorest countries – but for three things.  The first is popularity and political will.  American citizens will quickly begin to question this course of action when body bags start coming home from foreign countries where we faced no security risk.  Real nation-building takes 50 to 60 years (or longer).  The second is cost.  We are already facing spiraling deficits and an enormous public debt without taking on the business of nation-building.  There are not just one or two countries in the abjectly poor category, and nation-building is expensive.  The last is legitimacy on the world stage.  Lack of legitimacy could lead to insurgency by citizens attributing evil intentions or to a new wariness on the part of our former allies that could have broad implications for other foreign policy efforts.  In reality, a sweeping strategy of military intervention for humanitarian reasons is a pipe dream.

What Are Our Other Options?

The other options I’ll call “Watch and Wait” and “Bottom Up.”  The “Watch and Wait” strategy is about seeking the right opportunity to intervene from a top-down standpoint.  The right opportunity would suggest a solution that was low-conflict, low-cost, and high-legitimacy.  For instance, a violent civil war might suggest a United Nations peacekeeping mission that could include an element of governance structure installation.  Alternatively, the rise of a benign dictator might suggest an advisory role in infrastructure development, education, health initiatives, and monetary policy.  Or a successful democratic revolution would suggest support in advising and monitoring the election process, as well as helping the new leader establish the governance structures necessary for a burgeoning democracy (e.g. constitution).

The “Bottom Up” approach is about a systematic approach delivered through aid organizations or direct to citizenry.  It could include elements of venture capital, education, established governance charters and standards (as suggested by Paul Collier), standards for contracts and transactions, consulting services, small-scale technology infrastructure, other forms of knowledge-sharing, and efforts to build a shared sense of community.  Its objectives are the same as the top-down approach, however – to remove constraints to utilizing open networks of exchange.  There are a number of “Bottom Up” models that exist today, though with varying degrees of effectiveness.  

The  Future of the United States:  Global Is a Mindset

We in the United States sit in a padded cell of a bubble.  I don’t hope to convince those Americans who don’t hold a passport, but for those on the margin, I tell you the time has passed when we could think only of ourselves with impunity.  In London where I live now, I get asked all the time why Americans are so ignorant.  My honest answer – “because we could afford to be.”  We have been a large country bordered by two oceans and two countries who pose no security threat.  People, wherever you find them, tend to care about what is relevant for them to care about.  So if you live in the middle of the country, China and Russia seem very far away.

This is no longer the case.

The world as an interconnected global system has been lauded in the past decade as something economically wonderful.  But as we have seen in the past couple years, globalization carries with it risks.  With the rise of competing powers (with nuclear weapons), we are faced with a post-American world.  It is not the German Prussian elites whose hegemony is endangered today, it is our own.  

But we are not a small group of ruling elites hungry to retain power.  We are “a nation, conceived in liberty, and dedicated to the proposition that all men are created equal.”  We need to start thinking in terms of all people, in terms of our shared humanity.  Our national boundaries are synthetic, and while they are still useful, we need to start thinking in new terms.  If you look at our national economic statistics, many of them are becoming obsolete.  Our companies operate fluidly throughout the world.   Half of the revenue of our biggest companies comes from outside the U.S.  Much of the knowledge embedded in the products and services we sell came from outside the U.S.  Access to global knowledge flows and the ability to learn and innovate from people outside our country offers us enormous advantage.  We are still among the most business-friendly, agile and open of countries.  But we can no longer live one foot in globalization and one foot in insularity and protectionism.  That old strategy is a guaranteed route to obsolescence.  

As the United States, we have the unique opportunity to break the strategic tradeoffs that have hampered us for so long.  We can shape this world, not arrogantly and not by ourselves, but with clear intent.  We have to change the game through a categorical consistency with our values, clear signals of our intentions, continuing to tell the story in a powerful way, a captivating transparency, real commitments of dollars and strategic chips, and a deep understanding of our common shared psychology as human beings and what drives us.

We cannot be naïve.  There are sovereign powers that think about power as a zero-sum game, us versus them.  We will continue to ensure our security, but we will do it emphatically in the framework of our values – equality and the inalienable right to life, liberty and the pursuit of happiness – not just for American citizenry but the citizenry of the world.  This is a necessity.  Power is not what it once was.  It is slowly being redistributed from sovereign states to individuals and non-state actors.  Inequality on the other side of the world threatens geopolitical stability and our security.  We will never win a war with any finality ever again without winning the war of ideas.  Our system of government and norms may not be appropriate for every nation, but our values can be shared in common with all members of humanity.  Global is a mindset.  

[i] There remains an open question as to whether this “perfect storm” of financial innovation, untoward risk, abuse and misaligned incentives was truly such a coincidence.  After all, much of the capacity for this “perfect storm” existed for some time, which leaves us looking for the match that lit the fire.  If we narrow the list down to just the lower cost of money due to (1) the Jackson Hole consensus among central bankers (i.e. the focus on consumer price index and ignoring of asset prices in the central bankers’ roles as overseers of price levels, resulting in a low Fed funds rate) and (2) high Chinese savings rate, the list still might be comprehensive.  Money flows like water downstream and across borders, changing incentives for innovation, risk and abuse.

[ii] Otherwise known as over-the-counter (OTC) derivatives, which were new instruments and largely unregulated.

[iii] Home ownership has historically been encouraged by the US government through tax deductions and non-recourse loans as a way to increase conservatism, ensure respect for property rights, and fend off communism.  Home ownership rates are significantly lower in European countries.  

[iv] The Volcker rule currently limits proprietary trading by banks and puts constraints on bank size but unfortunately does not impose capital requirements.  There’s an argument here that if we as a society have made decisions that essentially institute a moral hazard, i.e. that we will provide bailouts in cases of systemic risk, we should also institute rules to avoid these specific situations using as precise a scalpel as possible.