Foreign Superpower Role & Obligations: The New World Order Part III by Bill O’Grady of Confluence Investment Management.

As promised last week, this week’s report will focus on two themes. First, we will examine policymakers’ attempt to resolve the tensions created between the desires of its domestic constituencies and foreign superpower obligations. There are going to be periods when the requirements of the hegemon role adversely affect the segments of society within the superpower. The political class must navigate these divergences in such a way so as to keep domestic tranquility and fulfill its foreign obligations. We will offer a history of how the U.S. managed these differences, with an analysis of Roosevelt’s political configuration and how the Reagan Revolution adjusted to the failures of the first program. Second, we will detail these periods with charts. Third, we will explain the capability and willingness of the U.S. to continue providing the global public goods to the world.

The Political Coalitions

As noted above, the superpower role requires political leaders to juggle the duties of providing global public goods and, at the same time, manage the changes and distortions that providing these goods causes to the domestic economy and the political system. The superpower has to run the global and domestic economy and bear an unusually large burden both diplomatically and militarily. To make this work, the political class has to create narratives to “sell” the program to domestic interests and, at the same time, create policies to meet both the external and internal goals.

From the end of WWII until 1980, the main coalition was the Managerial/Rentier class and the Right-Wing Populists.1 The Entrepreneurial Class and the Left-Wing Populists were mostly marginalized. Starting with “The New Deal,” the government created a middle class social safety net designed to help society recover from the Great Depression and WWII. This was the Roosevelt Coalition.

This political coalition created conditions that opened up a “wide road” to the middle class, which was mostly populated with Caucasian men and their families. In effect, a household could achieve financial stability with a modest degree of education by acquiring low-skilled, high-paying jobs, mostly in manufacturing. The combination of high marginal tax rates, which discouraged entrepreneurship, and onerous regulations created concentrated industries that allowed for the creation of large and powerful unions. During this period, the U.S. had one telephone company and three primary automakers. Technology was “dribbled” into the economy to avoid disrupting the job market. Much of the potentially disruptive technology was “bottled up” in the big research laboratories or in the expanding defense industries.2

The expanding middle class not only maintained domestic tranquility from 1945 into the mid-1960s, it also met two key hegemon goals. The steady expansion of U.S. consumption allowed the U.S. to meet the importer of last resort role, which is necessary to provide the global reserve currency. Foreign nations need to run trade surpluses with the reserve currency provider and that nation needs to buy the imports the rest of the world wants to sell. Because the U.S. economy dwarfed the rest of the world, the American consumer was able to provide the reserve currency without triggering an unsustainable trade deficit.

Superpower Role

This chart shows the relative size of U.S. GDP compared to the rest of the world. Until the mid-1970s, the U.S. accounted for 24% or more of global GDP. In addition, the expanding labor force also provided workers for the growing defense industry.

In the late 1960s, two factors emerged that undermined this arrangement. First, beginning in the mid-1960s, inflation began to rise persistently. The inefficiencies caused by stifling entrepreneurship, excessive regulation and industry concentration created an environment for inflation to develop. Mostly stimulative fiscal and monetary policies also lifted price levels. Reducing inflation became a major concern. Second, the Left-Wing Populists, who were paid “lip service” in the Roosevelt Coalition but given little economic or political power, began to aggressively press for inclusion into the existing coalition. Redistribution, gender equalization and affirmative action policies were implemented under Johnson’s Great Society program. Unlike Veteran’s Benefits, various tax expenditures3 and Social Security, which were designed for the middle class, these new programs mostly helped the poor. These shifts were not well received by the Right-Wing Populists, putting the coalition in flux during the 1960s into the 1970s.

In addition to these domestic concerns, by the 1970s, support for the Cold War was waning. Opposition to the Vietnam War led to deep societal divides that were joint to the struggles of women and minorities among the Left-Wing Populist class. The madness of the nuclear arms race,4 the inconclusive Vietnam War and persistent inflation undermined confidence in America and called into question its ability to lead the West against the Communist threat. Nixon’s decision to close the gold window in 1971 in response to excessive trade deficits with Europe and the drain of gold from the U.S. further weakened America’s status. By the end of the decade, which saw the Iranian Revolution and the hostage crisis along with a second oil crisis, there was growing concern that the U.S. was not up to the task of integrating the hegemon role and sustainable economic growth.

Ronald Reagan was elected into this situation in 1980. Reagan, following in the policy footsteps of British PM Margaret Thatcher, deregulated key industries, lowered marginal tax rates, expanded globalization and deregulated the economy. The lower marginal tax rates and deregulation dramatically expanded the productive capacity of the economy. Globalization encouraged firms to move production offshore to reduce costs. These policies, coupled with tight monetary policy, led to a steady drop in inflation.

The Reagan Coalition was created by jettisoning the Right-Wing Populists and including the Entrepreneurial Class with the Managerial/Rentier Class. Since this coalition, by itself, couldn’t create a majority, center-left and center-right leaders within the ruling coalition tried to attract populists to their cause. In the popular press, this is known as “attracting the base.” The Reagan Coalition had no interest in creating economic policies that benefited the populist classes, which would entail reregulation and deglobalization. Instead, the ruling class tried to garner support by recommending various social policies. In practice, few of these social policies ever become law.

The current ruling coalition has greatly benefited from the current economic policy mix and is loath to change it. Unfortunately, this policy mix has not favored the populist classes at all. Since the superpower role requires that the nation be the consumer of last resort, consumption levels need to remain high in order to supply the reserve currency to world markets. The Reagan Coalition’s solution to inflation led to weak income growth and rising income inequality, meaning that the hegemon’s consumption requirements could no longer be satisfied by income alone. In response, financial markets were deregulated and household debt rose sharply. The Great Financial Crisis in 2008 suggests that debt-fueled consumption growth probably isn’t feasible, meaning that the importer of last resort role is in jeopardy.

The Charts

To better understand the transition from Roosevelt to Reagan, we offer the following charts.

Chart #1: Tax Rates and Entrepreneurship

Superpower Role

This chart shows the highest marginal tax rate along with patent applications. Although the

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