Can external pressure precipitate change in a command economy like China?

I am going to talk here a little bit about the looming trade war between China and the United States. But I am going to come at it from a side angle via some historical analogies.

Common folklore in the United States says that the Soviet Empire collapsed in large part due to the efforts of American President Ronald Reagan and not due to internal forces. Others downplay Reagan’s role and see internal forces as more significant.

I want to briefly outline this debate and make a parallel to the financial crisis and the near collapse of the American financial system and ask a few questions about anti-Chinese protectionist rhetoric in this context. My basic question will be: How effective is external pressure in precipitating regime change or economic policy moves?

Let’s start off with the collapse of the Soviet Union. When Ronald Reagan died in June 2004, MSNBC ran an article, “Determination to destroy communism was a hallmark of his 8-year presidency” which eulogized the former President with credit for helping to destroy the Soviet Empire.

The article began:

He stunned the Soviet Union with his tough rhetoric, calling it an “evil empire” whose leaders gave themselves the “right to commit any crime.”

His famed “Star Wars” program drew the Soviets into a costly arms race it couldn’t afford. His 1987 declaration to Soviet leader Mikhail Gorbachev at the Berlin Wall — “Mr. Gorbachev, tear down this wall” — was the ultimate challenge of the Cold War.

Ronald Reagan’s determination to destroy communism and the Soviet Union was a hallmark of his eight-year presidency, carried out through a harsh nuclear policy toward Moscow that softened only slightly when Gorbachev came to office.

He is vividly remembered in Russia today as the force that precipitated the Soviet collapse.

“Reagan bolstered the U.S. military might to ruin the Soviet economy, and he achieved his goal,” said Gennady Gerasimov, who served as top spokesman for the Soviet Foreign Ministry during the 1980s.

The article goes on to assert that Reagan’s anti-Soviet stance was a significant departure from Jimmy Carter’s ‘mild detente’ [read: weak on defense], suggesting that this course change brought down the Soviet Union.  The article then provides yet more quotes from influential Russian dissidents to bolster this claim.

But is this really true?

Last November, an online survey demonstrated that Americans are alone in this view that external pressure applied by the Reagan Administration was principally responsible for the Soviet collapse.

The online survey of representative national samples asked respondents to assess the performance of nine political figures of the 1980s, and their effect in the eventual collapse of communism.

For Americans, Reagan is the clear winner with 69 per cent of respondents claiming he deserves a lot of credit or some of the credit for the collapse of communism. More than half of people in the U.S. also commend Gorbachev (56%) and British Prime Minister Margaret Thatcher (57%) for their efforts.

In Britain, only Gorbachev (57%) and Walesa (56%) clear the 50 per cent mark, followed by German chancellor Helmut Kohl (47%), Thatcher (45%) and Reagan (44%).

In Canada, Gorbachev is seen as the most important figure (65%), followed by Reagan (58%), Thatcher (56%) and Walesa (52%). Canadians are more likely to select Reagan and Thatcher as deserving “some of the credit”, and place former Canadian Prime Minister Brian Mulroney at the bottom of the list with 25 per cent.

The survey also shows that a considerable proportion of people in the two North American countries (47% in the U.S. and 44% in Canada) regard Pope John Paul II as an important player in the collapse of communism, while Britons (31%) are decidedly more skeptical.

–People Differ on Who Deserves Credit for the Collapse of Communism, Vision Critical

On some level, it’s irrelevant if the claim that Ronald Reagan ended communism is true because the winners get the spoils. And that means they get to impose their historical narrative on past events whether this narrative is true or not.

If external pressure did bring down the Soviet Union, an analogous claim could be made for the American financial system’s near-collapse because of the focus by regulators post-9/11 on terrorism to the exclusion of financial fraud.

Last month, Bill Black, a former S&L crisis regulator gave a speech on mortgage fraud and its central role in the housing bubble and bust. he asserts that lax regulation was at the core of why this fraud was allowed to occur. What I found interesting about Black’s lecture was the section on the FBI. He starts by commenting that the FBI gave a prescient warning in September 2004 in Congressional testimony that fraud and insider trading were rampant in the mortgage market. Black says:

[The FBI] didn’t simply warn there was an epidemic of mortgage fraud, they explicitly warned that it would produce an economic crisis if it were not dealt with. So what was done in response to a warning that clear?

Not a whole lot. In fact, Black says no one wants to unearth the fraud because the majority of it came from the lenders and not the borrowers. This is a bit like the 9/11 intelligence memo warning of an imminent al Qaeda attack:

RICE: I remember very well that the president was aware that there were issues inside the United States. He talked to people about this. But I don’t remember the al Qaeda cells as being something that we were told we needed to do something about.

BEN-VENISTE: Isn’t it a fact, Dr. Rice, that the August 6 PDB warned against possible attacks in this country? And I ask you whether you recall the title of that PDB?

RICE: I believe the title was, "Bin Laden Determined to Attack Inside the United States."

Now, during the S&L crisis there were 1000 investigators on the case. In 2009 there were 150 FBI agents on the case. And that’s a large part of the problem. After 9/11, more than 500 white-collar investigative specialist FBI agents were transferred from white-collar crime to focus on national security. Had these 500 extra FBI agents been available, perhaps the fraud would have been prosecuted. Similar tales are certainly available at other regulators like the SEC as the U.S. was more interested in connecting charities to terrorist sources than investigating mortgage fraud.

So, in a very real sense, one could make the same argument about 9/11 and al Qaeda causing the collapse of the United States’ financial system  that is made about Reagan causing the collapse of the Soviet economic system. I do not find this line of thinking persuasive. But, the situations are indeed analogous.

So, here’s my question again: How effective is external pressure in precipitating regime change or economic policy moves?

We see that most Americans believe it was very effective in bringing down the Soviets. Most believe it was effective in ending Apartheid in South Africa. It has not been so successful in Cuba or North Korea. But could external pressure work in Iran or even in China?

My general take is no; politicians, especially in command economies, are relatively unconcerned with external pressure. I used to be a foreign policy specialist. And, despite my role, I was keenly aware of the primacy of domestic issues over foreign ones in a politician’s decision-making. What the ruling elite in command economies care about is social unrest that stems from a lack of civil liberties and economic progress. Even in the United States, this is true.  Do you think American politicians will yield to Brazilian threats to retaliate for American cotton subsidies? Of course not.

Threats don’t work. The only thing that can work is inflicting economic pain and creating social unrest. Yes, autarky hasn’t brought the North Koreans or Cubans to heel; nor did it topple Saddam Hussein. However, implicitly, this is the power that some American political historians ascribe to the policies against South Africa and the Soviets. They assert that it was the economic pain that caused those governments to eventually yield.

So, as Americans look to threaten to punish China for China’s protectionist exchange rate policy, we should all understand that these threats will have no effect.  The Chinese will not do anything because of threats. More likely, they will dig in their heels. The Telegraph’s Liam Halligan has it right when he says:

When it comes to China, the West needs to face the truth. The more America calls for China to revalue the longer Beijing will take to do it. Chinese politicians are as unlikely to buckle in the face of Western pressure as their Western counterparts would be given a tongue-lashing from Beijing.

China’s government is petrified of social unrest. Given the importance of the export sector for continued high growth and jobs, this again makes it impossible to Beijing to be seen yielding to pain imposed by the West.

What is more likely to occur is that American politicians, pressured by the upcoming mid-term elections, will create binding legislation to retaliate against China for their undervalued currency. China will not budge – in part out of pride and in part out of need to prevent a hard landing. As a result, the binding legislation will become operative and a trade war will ensue.

For more on how a trade war would affect the global economy read Michael Pettis’ piece How will an RMB revaluation affect China, the US, and the world?. He notes that surplus countries like China have the most to lose and feels that the short-term losses for the U.S. will be less. I agree that surplus nations have the most to lose. But I disagree about the short-term effects on the United States; any economic shock to the United States will tip into a double dip recession, precipitating higher unemployment, a renewed meltdown in the financial sector and the attendant deleveraging. That is very bearish for equities, I should add. Moreover, the Chinese would make their UN Security Council veto work and stymie any efforts the U.S. makes toward controlling Iran. I see a lot more risk in a Chinese trade war for the United States than Pettis.

This is what I have labelled Murder-Suicide in Chimerica. But, I believe this could be where we are headed -  now more than ever.