The United States Still Runs the World

August 28, 2015

Reports of the death of American power have often been greatly exaggerated. In the 1950s the Soviet Union was thought to have surpassed the United States; today, the Soviet Union no longer exists. In the 1980s, Japan was widely regarded as on the verge of overtaking the United States; today, after more than two decades of Japanese stagnation, no one would take this scenario seriously. And in the 1990s, monetary union was considered likely to propel Europe to greater global prominence; today, the European economy is frequently in the world's headlines, but not in a good way.

Americans' anxiety about being overtaken is not new.

Now it is China's turn. Until recently, China, in many people's view, was poised to assume global leadership, if it hadn't done so already. Today, doubts about the Chinese economy's long-term prospects are rattling stock markets worldwide (including in the United States).

China matters, and its economic policy, including how the exchange rate is managed, must be taken seriously. But China does not run the world, and it is unlikely to do so anytime soon. The potential for global leadership still rests, believe it or not, with the United States.

The best case for taking China seriously as a world power is made in Arvind Subramanian's best-selling book Eclipse: Living in the Shadow of China's Economic Dominance, published in 2011. (The author, now chief economic adviser at India's finance ministry, and I were colleagues and sometimes coauthors at the International Monetary Fund and the Peterson Institute for International Economics.)

One hopes that the Indian government will heed Subramanian's account of how China grew through exports of manufactured goods and associated productivity improvements. China also became integrated into global supply chains—producing things for companies elsewhere—on a previously unimaginable scale, and Chinese managers learned how to make better products.

But other parts of China's experience have served it less well over time. China ran a very large current account surplus during the early 2000s and accumulated a vast stock of foreign reserves—including at least several trillion dollars' worth of US Treasury debt. Although this looks impressive on paper, reserves of this magnitude are essentially useless. If China were to sell its US assets, the dollar would weaken, and US companies would find it easier to export and to compete against imports.

But Americans' anxiety about being overtaken is not new. There was great angst in the late 1980s when a Japanese company bought New York City's Rockefeller Center. In retrospect, that was one of the great nonevents of the 20th century. Similarly, Americans will most likely look back on China's accumulation of US government debt and simply shrug.

The bigger issue is China's exchange rate policy. For a long time, China prevented the renminbi from becoming overvalued—and this was good policy, as Subramanian's research confirms. But in the early 2000s, China went too far. For reasons that are still debated, the renminbi became massively undervalued; exports were much higher than imports, and the current account surplus reached more than 10 percent of GDP. Instead of letting the renminbi appreciate and gradually reducing their reliance on export markets, the Chinese authorities preferred to accumulate foreign reserves (US Treasury debt).

Now China has to figure out a way to sustain growth when demand in the rest of the world is sluggish. A return to a substantially undervalued exchange rate would almost certainly provoke an international response, including from the US Congress. But switching suddenly to domestic-led growth is not easy. China will not collapse (it is not the Soviet Union), and Japanese-style stagnation is also unlikely. But China is aging fast—and could become old before it becomes rich.

Every decade, important people predict the end of American power. And there are reasons to be concerned—particularly when some US politicians refuse to acknowledge the nature of America's global role. For example, the United States built the world's trading and monetary system 70 years ago, but now Republicans in Congress refuse to support change at the International Monetary Fund—including sensible reforms that almost all other countries favor.

Still, it is the United States that is currently leading the push for freer trade across the Pacific and a substantial reduction in barriers to trade with Europe. If America gets the rules right—favoring ordinary citizens, rather than footloose corporations—its trade initiatives will make a major contribution to global growth and its own prosperity.

Likewise, in terms of monetary policy, the major issue for the world over the next year is when and how much the Federal Reserve will raise interest rates. As US monetary officials gather for their annual Jackson Hole conclave, they will consider myriad relevant dimensions of the global economy. But the policy-setting Federal Open Market Committee will move interest rates based almost entirely on its collective read of US economic circumstances. Once again, the rest of the world will react to what the United States does.