A Theory of Economic Coercion and Fragmentation

Hegemonic powers, like the United States and China, exert influence on other countriesby threatening the suspension or alteration of financial and trade relationships.Mechanisms that generate gains from integration, such as external economies of scaleand specialization, also increase the hegemon’s power because in equilibrium they makeother relationships poor substitutes for those with a global hegemon. Other countriescan implement economic security policies to shape their economies in order to insulatethemselves from undue foreign pressure. Countries considering these policies face atradeoff between gains from trade and economic security. While an individual countrycan make itself better off, uncoordinated attempts by multiple countries to limittheir dependency on the hegemon via economic security policies lead to inefficient fragmentationof the global financial and trade system. We study financial services as aleading 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 increasesdisproportionally as the hegemon approaches controlling the entire supply of a sectoralinput, we estimate that much economic security could be achieved with little overallfragmentation by diversifying the input sources of key sectors currently controlled bythe hegemons.