A Theory of Economic Coercion and Fragmentation

Hegemonic powers, like the United States and China, exert influence on other countries by threatening the suspension or alteration of financial and trade relationships. Mechanisms that generate gains from integration, such as external economies of scale and specialization, also increase the hegemon’s power because in equilibrium they make other relationships poor substitutes for those with a global hegemon. Other countries can implement economic security policies to shape their economies in order to insulate themselves from undue foreign pressure. Countries considering these policies face a tradeoff between gains from trade and economic security. While an individual country can make itself better off, uncoordinated attempts by multiple countries to limit their dependency on the hegemon via economic security policies lead to inefficient fragmentation of the global financial and trade system. We study financial services as a leading application both as tools of coercion and an industry with strong strategic complementarities. We estimate that U.S. geoeconomic power relies on financial services, while Chinese power relies on manufacturing. Since power is nonlinear and increases disproportionally as the hegemon approaches controlling the entire supply of a sectoral input, we estimate that much economic security could be achieved with little overall fragmentation by diversifying the input sources of key sectors controlled by the hegemons.