A Theory of Economic Coercion and Fragmentation

Global powers, like the United States and China, exert influence on other countries by threatening the suspension or alteration of financial and trade relationships. We show that the mechanisms that generate gains from integration and specialization, such as external economies of scale, also increase these countries' power to exert economic influence because in equilibrium they make other relationships poor substitutes for those with a global hegemon. We study how smaller countries can insulate themselves from geoeconomic pressure from the great powers by pursuing anti-coercion policy. We show that while an individual country can make itself better off, uncoordinated attempts by multiple countries to limit their dependency on the hegemon lead to unwinding the global gains from integration and fragmenting the global financial and trade system. Countries resort to inefficient home alternatives, the more so hegemons are expected to want to exert their influence in disruptive ways. An integrated liberal world order emerges as an equilibrium when the hegemon's incentives are well aligned with the world economy, politically and economically. Generically, the world economy fragments along political and economic alignments. We study a leading application focusing on financial services and payment systems as both a tool of coercion by the hegemon and an industry with strong strategic complementarities at the global level.