How Europe and the U.S. Dropped the Baton

As the United States and Europe muddle through internal institutional crises, the wealth holders of the world wonder how and where to store their assets. In the answer to that question lies the future of the global economy. It looks as though the transition from a world economy dominated by the North Atlantic to a global economy dominated by Asia will be more difficult and far less linear than had been thought.

Back to the future

Although the concept of national income (GDP) was invented only in the 20th century, the late Angus Maddison, the visionary British economic historian (whose most famous work was undertaken in the Netherlands and who died in France last year), constructed detailed estimates for Northern economic activity going back to the early 19th century. He followed this scholarship with bold efforts to reconstruct global economic developments going back to the year AD 1.

Maddison’s well-known thesis was that China was the largest global economic power throughout most of the past 2,000 years. Not only were many essential products (from paper to gunpowder to noodles) invented in China, but the organization and management of large bureaucracies — the basis of modern states — owes at least as much to Chinese innovation as to any Roman or Western contribution.

Indeed, China was a highly organized society, heavily dependent on writing and recordkeeping, when the countries of Northern Europe were the homelands of a collection of illiterate warring tribes.

Maddison’s striking conclusion, which he reached in the first years of the 21st century, was that the prospective rise of Asia, dominated by China, marked simply a return to global preeminence of the region that had led throughout most of the history of civilization. Save the period 1500-2000 — in which Europe and its offspring dominated — China, the once and returning world leader, was the dominant world power.

The rise of the West

European dominance developed slowly when viewed from the perspective of modern change, but it unfolded rapidly compared to earlier human development. Maddison estimates that over the second millennium, as Europe rose to global preeminence, world population rose 22-fold. Meanwhile, per capita income increased 13-fold, but world GDP rose by a staggering nearly 300-fold.

This contrasts sharply with the preceding millennium, when world population grew by only a sixth, and there was no advance in per capita income. Yet from the year 1000 to 1820, the advance in per capita income would remain a slow crawl compared to what has followed.

From year 1000 to 1820, world average income rose by only about 50%. Most of the growth in total income went to accommodate a 400% increase in population. Since 1820, world development has been much more dynamic. Per capita income rose more than 800%, population more than 500%.

The foundation for subsequent Western dominance was laid between the years 1000 and 1500. Gradual technological innovation increased food security and reduced the incidence of famine, permitting a growing proportion of agricultural output to be channeled from subsistence production toward the industrial and commercial labor force.

In addition, it was used as inputs into clothing production (wool), wine and beer (cereals and vines) and fodder crops. There was the emergence of international specialization, with English wool exported to Flanders for production of cloth that was traded throughout Europe.

Increased use of water and windmills augmented the power available for industrial processes in new industries such as paper making as well as grain milling and textiles. Improvements in mining and metallurgy helped transform and expand European weapons production. Improvements in shipping and navigation techniques from the 11th to the 15th century underpinned the increase in trade in the Mediterranean, the Baltic, the Atlantic islands and the northwest coast of Africa.

Innovation in service activities was relatively rapid, with advances in banking, accountancy and marine insurance. The knowledge base was preserved and expanded through the development and spread of universities, the growth of scholarship and, at the end of the 15th century, the introduction of printing.

From 1000 to 1500, the proportion of Northern Europe’s population in towns with more than 10,000 people rose from zero to 6%, signaling the expansion in manufacturing and commercial activity.

From 1500 onward, European control of the seas, its use of slave labor in depopulated colonies and the development of new technologies created the transformation that culminated in the Industrial Revolution. The pace of change accelerated throughout this period. This is illustrated by one critical measure: life expectancy.

In the year 1000, the average infant could expect to live about 24 years. A third would die in the first year of life, while hunger and epidemic disease would ravage the survivors. There was an almost imperceptible rise up to 1820, mainly in Western Europe. Most of the improvement has occurred since then. Today, the average infant can expect to survive 66 years.

The 20th century saw the Industrial Revolution — the improvements in technology, literacy and civic organization — which had taken centuries to develop in Northern Europe and its offshoots, spread back to Asia, from which global dominance had slowly ebbed. First Japan, then Korea and several smaller countries, and now China and South Asia have entered, and in some cases completed, the catch-up process.

Improvements in communication and transportation technologies have permitted the processes of technical change, industrialization, urbanization, demographic transition and human development to proceed at breakneck speed. What took centuries in Europe is taking only decades in Asia.

The empire strikes back

The decline of China arguably hit its nadir in the middle of the 20th century. After 1958, the collectivization of Chinese agriculture led to a great famine. Over the next three years, there were about 30 million additional deaths. Colonial dismemberment of the once-great Chinese empire, followed by corrupt and then fanatical domestic rule, threatened the very survival of the Chinese masses.

A mere 50 years later, we stand at the threshold of China’s ascension to become the largest economy on earth. With the Chinese population so much larger than that of North America or Europe, this outcome is all but assured. It will be several more decades before Chinese average income levels reach North Atlantic levels — and over this period, rapid economic growth in China, as in India, is almost certain.

Not content simply to focus on catching up, Asian economies, notably Japan and Korea as well as China, are now the world leaders in generating new ideas, as measured by patent applications by residents. The number of applications for patents in China passed the number in France in 1998, the UK and Russia in 2000, Germany in 2003, Korea in 2006 and the United States in 2009. Soon, Chinese patent applications will exceed those in Japan to lead the world, at least in terms of numbers.

Whether India’s economy, which has the benefit of having been spared China’s draconian population policies, eventually grows even larger than China’s is unclear. But it is virtually certain that more goods and services soon will be produced in China than in any other region of the world, and that the center of the economic world will remain in Asia for the foreseeable future.

With a bang

The arc of this historical transformation might have been anticipated, but not its speed. Within a few decades, Asia will produce more goods and services than the rest of the world put together. (That is less surprising when we note that 55% of the world’s population lives in East and South Asia.)

In contrast, future patterns of trade and capital flows are much harder to anticipate. This fact is driven home by the parallel collapse of the dollar and the euro.

The extent of the current financial crisis is not evident because of the simultaneous crises on both sides of the Atlantic. When wealth holders decide to unload some assets, they simultaneously decide to load up on others. Weakness in one store of value is most evident when portfolio managers rush to another.

Today, we face a situation in which the dollar and the euro, like two drunks, are falling all over each other. Gold and Swiss francs may be strong, but these cannot be safe havens for trillions of dollars and euros worth of wealth. Besides, as their prices rise higher and higher, these too face the risk of becoming bubbles that burst. “Sell everything” is not a viable strategy.

The fundamental problem is that some countries save a lot, and unless there are other countries that need to borrow for productive investments, the macroeconomic accounts will not add up. Borrowers will be found, but not borrowers who can be relied upon to repay. Today, Germany and Japan are the two nations that decade after decade have run big saving surpluses.

China has been a massive net saver as well ever since the Asian financial crisis of 1997. Within Europe, in the first decade of the 21st century, the south borrowed from Germany. But it looks unlikely that these debts will be repaid in full.

Globally, the big borrower has been the United States. But it looks increasingly unlikely that macroeconomic logic will prevail there as well. So euro-denominated paper is looking more and more like dollar-denominated debt. Greece and Italy’s euro-denominated debt is looking not like Germany’s euro debt, but more like the dollar-denominated debt of Argentina and Mexico.

U.S. Treasury debt is not fundamentally at risk of default, but there appears to be no consensus about how to run public finances sensibly and sustainably. The United States could default simply because the lunatics take over the asylum.

So those who save today, and those who have accumulated vast stores of wealth in the past, do not know how to store this wealth. As the importance of the North Atlantic region diminishes steadily, we may be heading for a financial crisis — out of which will emerge a new global financial architecture. Given the lack of vision and leadership on both sides of the Atlantic, what that system may look like is a great mystery.