“Then the Gods of the Market tumbled, and their smooth-tongued wizards withdrew,
And the hearts of the meanest were humbled and began to believe it was true
That All is not Gold that Glitters, and Two and Two make Four—
And the Gods of the Copybook Headings limped up to explain it once more.”

Rudyard Kipling wrote the above lines in 1919, the year after World War I ended. The war had delivered a fatal blow to international laissez-faire. It had shattered the dream of classical liberals that interdependence would put an end to national conflict. The claim of J.B. Say, that as a consequence of his celebrated Law of Markets “[a]ll nations are friends in the nature of things,” sounded rather empty to the veterans of the trenches. It well deserved a place in Kipling’s critique of Utopian liberalism.

The war had revealed England’s weakened economy. The U-boats had nearly starved the interdependent island, while England’s industrial capacity and financial reserves proved inadequate to sustain its position as a dominant power. Both Germany and the US had surpassed “free trade” England in industry at the turn of the century by creating large internal or otherwise politically protected markets. In the years before the war England had found itself in somewhat the same situation as the US today. British industries were blocked from exporting to most of the world by foreign mercantilist policies, yet its own empire was open to rivals. The US exported more steel to the overseas British Empire than did British firms, while British exports to the vast US market were restricted by tariffs.

World War I also made the US the world’s largest creditor nation, a status it held until 1983. The center of world finance shifted to New York from London and the dollar replaced the pound as the world’s key currency. The dollar still holds a central position, but the long-term prospect is not good. Continued large trade deficits will put downward pressure on the dollar, as will the shift in the net American flow of overseas investment income from positive to negative. A currency that is likely to drop in value makes a poor basis for a world economy. If policies do not change, the strong Japanese yen will replace the dollar by the end of the century. Already as a result of Japan’s economic prowess, eight of the world’s ten largest banks are Japanese. As of 1986, Japanese banks held 31.6 percent of all bank assets worldwide (the US held 18.6 percent). And every year that the trade imbalance continues, the financial situation worsens.

Free traders have dismissed the merchandise trade deficit by claiming that there can be no overall imbalance because dollars paid out for imports are recycled to the American economy as capital investment. This is true in a narrow accounting sense, but those who cannot look beyond their simple ledger sheets miss the bigger picture of the international realignment of wealth and productive capacity. Americans are consuming goods on credit, then selling off their assets to pay the bills. Such profligate behavior leads to a relative decline in favor of the creditors.

There are two basic categories of foreign investment: direct investment in the ownership of enterprises (FDI), and portfolio investment (FPI) in long-term financial instruments. Direct investment accounts for about one out of every six dollars of foreign investment in the US. The Commerce Department has estimated that at the end of 1988, 15 percent of American manufacturing was controlled by foreign-owned firms. There was a record inflow of $58 billion in FDI in 1988, compared to only $17 billion in US direct investment placed overseas. The main factor cited by Commerce in their 1988 report on international direct investment was the basic profitability and stability of the American economy. Yet the US has always been attractive on these grounds. What is different in the 1980’s is that foreigners have lots of dollars to invest, thanks to the trade deficit and dollar devaluation. Another worrisome factor, this one cited by Commerce, is that foreigners “are becoming increasingly confident in their ability to compete with US firms in the United States.”

At the moment, the US economy (due to its vast size) is less influenced by FDI than are many other host countries. However, the effects will accumulate like those of a slow leak. It took the Titanic two and a half hours to sink after hitting the iceberg. Pointing only to current figures while ignoring the trend, which is what many free traders do in regard to investment flows, is like reporting after the first half hour that since the ship is still afloat there is nothing to worry about.

Some foreign investors are very ambitious. Masaaki Kurokawa, head of Nomura Securities, has predicted that California will become a joint US-Japan community based on Japanese money and managers and American land and labor. So enthusiastic is Kurokawa that he has even claimed that California will cease to be considered part of America. This is farfetched, perhaps, but economic imperialism has a long history. The United States has used it to influence events in foreign lands, so why do American leaders believe others will not?

The shift in investment flows marks a waning of American wealth and power. During the 1975-80 period, the US was the source of 44.2 percent of the world’s international direct investment funds. In the 1980-85 period this dropped to 19.3 percent. During the 1982-87 period, US firms acquired $23.4 billion worth of foreign companies, but foreign firms bought up $101.9 billion worth of American companies. State governments in the US know where the money is today. More states have offices in Tokyo than in Washington. Several states have been very aggressive in courting FDI, hoping for local gains even at the cost of undermining the national economy.

Often it is said that it is better for foreign firms to produce in the US than simply to export goods produced overseas to the American market—that at least the factories, jobs, and tax base are in the US. There is some truth to this—at least the argument recognizes the damage done by imports—but it is not the whole story. It overlooks the role of FDI as a market extension strategy, as a way to penetrate overseas areas. About one-third of exports to the US go to foreign affiliates in the US; components to be assembled in production, capital equipment and supplies, even the materials and personnel to build the facilities themselves originate abroad. These American affiliates are “hollow” or “beachhead” corporations. As they expand, so does the trade deficit. American-owned affiliates overseas play the same role in boosting US exports. This is why a shift in the balance between American and foreign multinational firms affects the domestic economy so strongly. As the market share of foreign business empires expands, the market share remaining for American firms shrinks. And since foreign firms have access to low-cost capital (the cost of capital in Japan is half that of the US), they can at present expand when American firms are unable to.

Victory in these commercial struggles cannot be a matter of indifference to governments. As Princeton’s Robert Gilpin reminds us in his Political Economy of International Relations, the corporations that operate in the world arena

are not truly multinational; they are not divorced from a particular nationality. Home governments not only have the incentive but also may have the power to fashion commercial and other policies designed to benefit their own multinationals at the expense of competing firms and other economies.

The money involved in foreign portfolio investment is even greater than in direct investment. Private FPI accounts for 60 percent of America’s $1.5 trillion (and growing) foreign debt. It grew at an annual rate of 50 percent between 1980 and 1987. Over this period, foreign activity shifted from Treasury securities to corporate bonds to the stock market and back. In 1985, bonds of American corporations sold overseas equaled one-third of the bonds issued publicly in the US. In 1986, foreigners bought 25 percent of all the newly issued US corporate equities, as well as 15 percent of all newly issued corporate bonds. In 1987, the inflow of private FPI roughly equaled all individual savings generated by Americans.

Free traders argue that the influx of capital boosts domestic economic growth, and this is true. But again their focus is too narrow. The dollars start and end in the US, recycled through foreign hands. Would it not be better if this capital stayed in the US to begin with, earned by American firms selling in the domestic market and reinvested by and for Americans? The problem is as much cultural as economic. American society is far more interested in present consumption than future growth. Both private and public spending levels rest on debt, with a growing dependence on foreigners for financing.

This is economically unsustainable and politically unwise. A saturation point will be reached. A slowdown in the US economy, a political crisis, the onset of inflation or a further slide in the dollar will increase the risk to foreign holders of dollar-denominated assets. If the country is still dependent on foreign borrowings when that happens, the result will be higher interest rates and a dramatic slowdown in the domestic economy.

To pay off debt and interest charges, the US will have to return to a trade surplus or suffer the downward spiral of accelerating asset sales. The market solution is massive dollar devaluation to cut imports and boost exports. However, this also reduces the terms of trade, so that an even larger transfer of real goods and assets is required. Debts are claims against future income, and current policy is making these claims larger.

The proper solution is to end both the trade and budget deficits. Either a tax increase or a budget reduction would accomplish this, though the second is preferable. The private sector cannot stand a further shift of resources to government if it is to recover the ground lost to foreign competitors. Indeed, tax cuts to encourage savings and investment are vital elements of any industrial policy. The reduction in aggregate demand necessary to solve the debt problem should be managed at the expense of imports. It would be self-defeating to slow the domestic economy by taking the hit at home. That means intervention to curtail imports so that 1) domestic demand can be maintained even as its aggregate drops, and 2) the country can move to a trade surplus without gutting the dollar.

The US also needs to escape its dependence on foreign capital for political reasons. A “globalized” capital market is likely to become more sensitive to international tensions and crises. And from this will come greater pressure on the US to avoid conflict through appeasement. In the past, the nervousness of allies and neutrals over confrontations or military operations has been expressed in diplomatic terms that a determined administration could politely ignore. But if that nervousness can now be expressed by a drop in the stock market, a jump in interest rates or factory lay-offs, with the distress this will cause among the business community and domestic electorate, any administration will become even more wary of taking strong action. Foreign firms have already organized their American employees to campaign for policies that favor their interests, while millions of dollars are funneled to candidates, former officials, and think tanks to influence decisions. Given the pacifism of our allies and trading partners in Europe and Japan, the danger is not just that America’s enemies will control its economy, but that its friends will. Indeed, the “peace in our time” rhetoric from the Reagan-Bush White House over the last five years may already be a sign of this.

Such an inhibition would be the negation of Great Power status. A Great Power by definition is one that has the freedom to act unilaterally, to take as little or as much of the outside world as its interests dictate. The kind of economic interdependence now being promoted would have the same effect on the United States that being tied down by the Lilliputians had on Gulliver.

The relative decline of the United States and the diffusion of power across a multipolar globe bodes ill both for Americans and the world at large. It must be remembered that what stability there has been during the last half of this century has been due to the preeminence enjoyed by the US since its triumph in World War II. As William R. Thompson noted in his study On Global War.

The more pronounced and unambiguous the postwar hierarchy of prestige, as reflected in the dominance of the leading power, the more likely the system to enjoy a period of peace and stability. . . . Their decline, however, creates situations of conflict and instability.

There has been a world economy for five hundred years, but it has not depended on anything as dubious as an “invisible hand.” The stakes are too high. It is national power that writes the rules of the game, and protects the property rights of citizens and clients. The system has been capitalist without being laissez-faire: the dominant power provides the bulk of investment capital and a stable currency. It does not do this out of altruism, but because it profits from its position as the most advanced economy. It is dominant because it is able to outperform rivals in the leading sectors of the economy.

Unfortunately, the United States has been losing ground in all these leadership categories. Current trade and investment problems are symptoms of a deeper malaise. The downward trend started in the 1970’s, but became more evident in the 1980’s. Between 1972 and 1987, American manufacturing productivity increased only one-third as fast as West Germany and one-eighth as fast as Japan. During 1983-88, US fixed investments’ share of GDP was one-half that of Japan. American growth since 1982 has depended primarily on increased labor participation; more workers rather than more productive workers. In the modern age, that is the antithesis of progress. Not only is this poor economics, it is harmful social policy and a dangerous national strategy.

As disturbing as this trend is, even more disturbing is the non-response of so many. To spend one’s efforts trying to explain away or rationalize ominous developments rather than seek solutions is to become part of the problem. For when we cease to worry about the nation’s relative standing in the world, the situation is truly lost.