Sri Lanka and global trade shock

Sri Lanka must undertake a crash course to build up the administrative machinery necessary to enact a real industrial policy capable of channelling investment into strategic economic sectors

We are entering a dangerous period in which direct military conflict is possible. Under these circumstances, and as a small country, it behoves Sri Lanka to focus on its own domestic relations and redistribution, rather than trying to hitch its ride to one geopolitical bloc or another. At best, it must work with the longer-term idea of delinking from this unequal and unstable global order. It can consider the scope for alliances with countries in the global South led by progressive governments to facilitate mutually beneficial trade and investment

The Trump trade shock is a massive blow to the global order. It represents the biggest rupture since the end of the Bretton Woods system in the 1970s. In fact, it could have greater consequences, even inviting global economic disintegration and geopolitical conflagration. How does a small country like ours respond to this crisis and what policies should we adopt?

The current upheaval was not unexpected. The fallout of the Global Financial Crisis of 2008, leading to Brexit and the election of Donald Trump in 2016, were clear signs of a global order that was coming apart. But for Sri Lanka and other countries of the global South, the option of preparing for such an eventuality through policies of self-sufficiency were denied under the watchful eye of the International Monetary Fund (IMF) and its programs. In addition, domestic policymakers were beholden to the ideology of free markets.

We are now paying the price. However, in some elite quarters the illusion continues that the broken global order can be put back together, or that some external power will lift us out of this crisis. It is as if they are hoping Humpty Dumpty can be put back together with all the King’s horses and men. Instead, a radical rethinking of our economic policies is imperative to confront this great global unravelling.

Collapse of Bretton Woods

To explain the unravelling of the global order, we must analyse the factors behind the current predicament. Near the end of World War II, Western powers led by the US came together to create the Bretton Woods system, which was named after the venue of the conference in New England. The system, which included the creation of the IMF and the precursor to the World Bank, depended on core countries having space to pursue their own domestic policies such as full employment.

The goal was to overcome the threats of financial disruptions and trade wars, which had originally contributed to the Great Depression of the 1930s. While this system worked for a time after World War II, however, eventually it experienced pressures due to the geopolitical dynamics of capitalism. They led to the breakdown of the international monetary system.

As a response to inflationary pressures, the US unpegged the dollar from the price of gold, effectively ending the fixed exchange rate system. This break constituted the first major shock to the international monetary system in the 1970s. Among the key reasons for taking the dollar off the gold standard included the growing US fiscal deficit because of its war in Vietnam. In addition, there was rising external manufacturing competition from Germany and Japan, which had recovered from World War II.

As the political economist Fred Block wrote in ‘The Origins of International Economic Disorder: A Study of United States’ International Monetary Policy from World War II to the Present’: “The struggle of the United States to increase its freedom of action in international monetary affairs destroyed the old Bretton Woods system. Step by step, the United States either broke the rules of the old order or forced other countries to break them. The rule-breaking was deemed necessary at each step to save the international monetary system from even greater crisis” (p.203).

The shift from a fixed to a floating exchange rate, however, did not simply end the ‘stagflation’ of the 1970s, or the combination of low economic growth with rising inflation. Rather, it played a key part in the financialisation of the global economy. The US could benefit from petrodollar recycling. Oil exporters flush with cash from the OPEC oil shock purchased US Treasury securities, which strengthened the dollar’s role as the world reserve currency. Bank lending diversified, and capital markets developed further, eventually becoming a key source of international liquidity.

The floating of the dollar, however, was only one facet of a much broader reconfiguration of global capitalism. The inflationary trend of the 1970s represented a pivotal moment in the distributional struggle between capital and labour. It anticipated conflict over essential decisions relating to investment. In the absence of a concerted political push towards democratic socialism, inflation created unprecedented pressure within capitalist economies.

Dealing with inflation using conventional macroeconomic tools requires adjustment, whether through monetary policy tightening, exchange rate changes, or a combination of measures. The US adopted a hawkish stance on interest rates with the Volcker shock of the late 1970s. It was named after the Chairman of the Federal Reserve at the time, Paul Volcker, and it increased unemployment in the US.

Eventually, the US was able to lower unemployment through the massive expansion of the retail and service sector combined with an influx of cheap goods imported from abroad. Although US manufacturing jobs contracted, they were replaced by low-wage employment. It was complemented by debt-driven consumption. Meanwhile, core pillars of the economy, from housing to healthcare, continued to experience sustained increases in price. Workers’ real wages stagnated, despite continued growth in productivity.

The US effectively became the world’s ‘consumer of last resort’, maintaining effective demand for global exports. At the same time, while its balance of payments deficit increased, it also continued to enjoy massive inflows of capital. The US appeared to manage the costs of adjustment for the world economy. Its financier classes benefited, accumulating from the world over.

This ad hoc solution to the problems of the international monetary system facilitated the rise of East Asia as the workshop of the world. Some of the region’s countries gained from the geopolitical support of the US during the Cold War. Eventually China attracted more investments in the East Asian region, and it rose as a peer competitor with the US.

Inequality also increased in the US. The process of financialisation, in which more sectors of the economy were opened to speculative investment, propelled the asset management economy. Wall Street, eventually supplemented by Silicon Valley, exercised massive control. Finance capital became emboldened by neoliberalism’s assault on the US regulatory apparatus. A key outcome was the subprime mortgage crisis leading to the Global Financial Crisis of 2008.

Indebted US homeowners eventually became unable to pay their loans. Their insolvency contributed to the seizing up of the financial system because complex derivatives were designed to repackage bad loans and conceal systemic risk. The US government bailed out the banks while the average US household continued to experience stagnation, if not decline, in real wages. The resentments and frustrations that the bailout created were a key factor in a political backlash, including the shock election of Trump in 2016.

The terminal phase of global unravelling

In this context, we can evaluate the effects of the crisis of the 1970s, its neoliberal solution, and the ‘terminal phase’ – as theorised by Giovanni Arrighi – in the unravelling of the global order. Now, we must anticipate the potential lines of further disintegration with the massive changes unleashed by Trump’s shock to the global trade order. Unlike the US’s break with the Bretton Woods system in the 1970s, this time Trump’s policies threaten to upend the basic linkages that have facilitated adjustment even under the unstable international monetary system.

Since the 1970s, international monetary transactions have been dominated by forces of financial speculation. Considering Trump’s tariffs, bankers and their advisory firms warn that it will be far more difficult to predict investment amid the instability caused by the much wider dismantling of the global order. Will Trump back down? His worldview is fixated on power and dominance, which is reinforced by the intransigence of his reactionary base. Will his actions provide a signal to those sections of capital willing to invest in the ‘America First’ agenda? That could ultimately lead to a breakdown of economic interdependence and create conditions for direct military conflict between the great powers.

These are a few of the long-term questions that must guide Sri Lanka’s own calculations in navigating an extraordinarily difficult external environment. They must be premised on clear-eyed recognition that the last nails are being hammered into the coffin of the extant global order. Now more than ever Sri Lanka must prioritise self-sufficiency, lest it be swept into geopolitical gamesmanship ultimately leading to greater tension and potentially even war.

The Trump regime has dismantled the pillars of the global development agenda, both aid and trade. Consequently, the world is likely to experience destruction as a solution to crisis in the global capitalist system. Bigger countries will focus on rearmament in the absence of a hegemon capable of guaranteeing the overall political, economic, and military security of the system.

This observation is not meant to imply an idyllic past. We must recognise that the dramatic inequalities within and between countries, which were engendered by the neoliberal order, are precisely what got us into the current predicament. Of course, some countries, such as ones in East Asia, may have benefited from the export-led model. But the overwhelming costs of adjustment were managed within a system that privileged financial speculation over the kind of modest redistribution that initially facilitated the recovery of the global economy after World War II.

Under today’s circumstances, Sri Lanka cannot even afford to rely on examples from the period of the 1950s and 1960s alone. A Non-Aligned Movement will take time to re-materialise. It further implies the long and difficult work of connecting struggles across many countries in the global South. Meanwhile, Sri Lanka is in the position of a country still dependent on the external sector, much as it was during the Great Depression of the 1930s.

This time, however, it does not even have an imperial sponsor like the UK willing to implement supports such as a food ration because of its own complex motivations and political pressures. Instead, Sri Lanka must recognise the gravity of the situation by immediately considering all available options when it comes to exiting the current IMF path. It must evaluate the full range of tools required. From import prioritisation with a robust planning strategy to macroeconomic policies like currency depreciation, it must not restrain its own ability to deal with the full effects of Trump’s tariffs.

There has been no coordinated international monetary system since the 1970s. What existed up to now has hinged on cross-border flows of speculative investment backed by powerful supranational institutions like the IMF. They ultimately enforced the geopolitical and economic objectives of the Western powers and their respective financial and corporate interests. Today, the kind of cooperation that would be required to establish a new international financial architecture has been practically ruled out given rising global antagonisms.

We are entering a dangerous period in which direct military conflict is possible. Under these circumstances, and as a small country, it behoves Sri Lanka to focus on its own domestic relations and redistribution, rather than trying to hitch its ride to one geopolitical bloc or another. At best, it must work with the longer-term idea of delinking from this unequal and unstable global order. It can consider the scope for alliances with countries in the global South led by progressive governments to facilitate mutually beneficial trade and investment.

In the meantime, Sri Lanka must undertake a crash course to build up the administrative machinery necessary to enact a real industrial policy capable of channelling investment into strategic economic sectors. Simultaneously, it must deal with the immediate shocks caused by the Trump tariffs. Anything less than this approach would be foolhardy. It would be based on wishful thinking and naïve grasping for a bailout from abroad that will not arrive.