Keeping America’s Edge

JIM MANZI

The United States is in a tough spot. As we dig ourselves out from a serious financial crisis and a deep recession, our very efforts to recover are exacerbating much more fundamental problems that our country has let fester for too long. Beyond our short-term worries, and behind many of today’s political debates, lurks the deeper challenge of coming to terms with America’s place in the global economic order.

Our strategic situation is shaped by three inescapable realities. First is the inherent conflict between the creative destruction involved in free-market capitalism and the innate human propensity to avoid risk and change. Second is ever-increasing international competition. And third is the growing disparity in behavioral norms and social conditions between the upper and lower income strata of American society.

These realities combine to form a daunting problem. And the task of resolving it turns out not, by and large, to be a matter of foreign policy. Rather, it compels us to consider how we balance economic dynamism and growth against the unity and stability of our society. After all, we must have continuous, rapid technological and business-model innovation to grow our economy fast enough to avoid losing power to those who do not share America’s values — and this innovation requires increasingly deregulated markets and fewer restrictions on behavior. But such deregulation would cause significant displacement and disruption that could seriously undermine America’s social cohesion — which is not only essential to a decent and just society, but also to producing the kind of skilled and responsible citizens that free markets ultimately require. Moreover, preserving the integrity of our social fabric by minimizing the divisions that can rend society often requires government policies — to reduce inequality or ensure access to jobs, education, housing, or health care — that can in turn undercut growth and prosperity. Neither innovation nor cohesion can do without the other, but neither, it seems, can avoid undermining the other.

Reconciling these competing forces is America’s great challenge in the decades ahead, but will be made far more difficult by the growing bifurcation of American society. Of course, this is not a new dilemma: It has actually undergirded most of the key political-economy debates of the past 30 years. But a dysfunctional political dynamic has prevented the nation from addressing it well, and has instead given us the worst of both worlds: a ballooning welfare state that threatens future growth, along with growing socioeconomic disparities.

Both major political parties have internal factions that sit on each side of the divide between innovation and cohesion. But broadly speaking, Republicans since Ronald Reagan have been the party of innovation, and Democrats have been the party of cohesion.

Conservatives have correctly viewed the policy agenda of the left as an attempt to undo the economic reforms of the 1980s. They have therefore, as a rhetorical and political strategy, downplayed the problems of cohesion — problems like inequality, wage stagnation, worker displacement, and disparities in educational performance — to emphasize the importance of innovation and growth. Liberals, meanwhile, have correctly identified the problem of cohesion, but have generally proposed antediluvian solutions and downplayed the necessity of innovation in a competitive world. They have noted that America’s economy in the immediate wake of World War II was in many ways simultaneously more regulated, more successful, and more equitable than today’s economy, but mistakenly assume that by restoring greater regulation we could re-create both the equity and prosperity of that era.

The conservative view fails to acknowledge the social costs of unrestrained economic innovation — costs that have made themselves powerfully apparent in American politics throughout our history. The liberal view, meanwhile, betrays a misunderstanding of the global economic environment.

To grasp the difficulty of this moment for America, we must see more clearly the pain involved in economic innovation, the price we would pay for stifling innovation, and the daunting social obstacles that stand in the way of balancing the two.

THE COST OF PROSPERITY

An economy built upon constant and relatively free innovation is inherently difficult to sustain in a democracy. This is not so much a matter of anti-market ideology as of the painful realities of economic change. Innovation forces change, and the pain involved tends to be felt immediately while the benefits are usually diffuse and harder to perceive in the short term.

It is therefore natural for people to organize to prevent the spread of significant innovation. The original Luddites were cotton weavers who, in the throes of Britain’s Industrial Revolution, responded to their displacement by automated weaving technology directly: They smashed looms. In America, people in similar situations rarely assault property en masse, but they do form political coalitions to pass laws that restrict innovation. It is understandable that the enormous waves of innovation always sweeping over a dynamic free-market economy will arouse great unease and opposition. But for that economy to prosper, the unease and opposition must be overcome.

This dynamic is often easiest to see at a distance. Consider, for instance, our country’s transition from an agricultural to an industrial economy. In 1800, America was a nation of farmers: About three-quarters of the labor force worked in agriculture. Since then, this share has been in almost continuous decline. By the eve of the Civil War, it was a little over half; by 1900 it was about one-third. Today, agriculture employs less than 3% of the work force. This has been great for consumers: Farming is now incredibly efficient, and food is cheaper and more plentiful in real terms than ever before in human history. American agriculture today is also a successful industry; in 2007, the U.S. exported more than $75 billion in agricultural products, and it has maintained a positive trade surplus in food for decades. But agriculture is no longer an industry that can provide employment for very many people.

The transformation described by these statistics was not easy. It produced enormous flux in social, political, and family relationships, and the instability lasted for generations. One of the most painful things about markets is that they often make fools of our fathers: Sharp operators with an eye for trends often outperform those who carefully learn a trade and continue a tradition. And the Industrial Revolution combined material deprivation for people who had known only farming with radical uncertainty about the future for much of the country. The appeal of political resistance to such change — like that embodied by the populists and William Jennings Bryan at the turn of the 20^th century — is easy to see. But their approach would have meant propping up emotionally resonant family farms while retarding the development of the industrial economy.

The industrial economy itself has witnessed a similar drama over the past 60 years. America has a very productive manufacturing sector, but that sector doesn’t employ much of the population anymore. At the end of World War II, manufacturing accounted for about one-third of the American work force. Today it accounts for about one-tenth. In terms of ­employment, we are no longer transitioning to a service economy; we are there. Over the same period, however, manufacturing has consistently represented about 15% of rapidly growing U.S. economic output. The chart below presents the classic image of massive economic transformation.

Ever-increasing productivity involves the use of human capital in new and constantly evolving ways. This is great for growth, but can be very hard on the people displaced. It is impossible to know, moreover, what new sectors will actually be productive and how they will develop. That is why the free play of markets with limited intrusion by the government is so essential. Almost all industrial policy ends up protecting existing institutions; this is a function of human nature and is not fixable by clever program design. As a result, industrial policy normally preserves jobs that a ruthless market would eliminate, and subsidizes the kinds of new technological developments that can be exploited by existing large firms. But these favored developments are rarely the sources of new high-wage jobs — and so such policy is more often a recipe for controlled stagnation than for continued growth. The attempt to protect ourselves from the pain of change ends up creating a sclerotic economy that, in the long run, puts everyone at greater risk.

One obvious response is to use the political process to both slow down the rate of innovation to an acceptable pace and redistribute the country’s economic output in a manner designed to maintain social harmony. That way, the pain of innovation is avoided and the pain of stagnation is mitigated — especially for the middle and lower classes, who are most vulnerable to the effects of both. This is the logic of the welfare state, and the direction pursued by much of Western Europe since the Second World War.

The problem, however, is that the United States does not exist in a vacuum, and making our internal economic changes less stressful is far from our only concern. We also face external challenges, especially rising competition from abroad. And our position in the global order means we cannot afford to go easy on ourselves and constrict innovation. Quite the opposite: We need rapid growth just to keep up.

A NATION AMONG NATIONS

American economic policy in the wake of World War II was developed by a generation of statesmen who dealt themselves a great hand of cards, and then played it brilliantly. It is hard to exaggerate the strength of America’s competitive position in the world economy in September 1945: The United States accounted for an absolute majority of all global manufacturing output, had the world’s most technologically advanced economy with ample supplies of natural resources, and could protect this state of affairs with an essentially invincible military that possessed a nuclear monopoly. Most of the rest of the world was in ruins, pre-industrial, or under the control of communist regimes that smothered economic initiative.

Most great powers throughout history would have reacted to such circumstances by seizing direct, long-term control over as much of the globe as possible. Instead, the United States established itself as first among equals in a loose coalition of nations that came to be known as the Free World. It also established a set of political and economic institutions and programs — the North Atlantic Treaty Organization, the Marshall Plan, the Bretton Woods system, the International Monetary Fund, the World Bank, and so forth — that encouraged rapid economic development within this coalition. Combined with the policy of containment toward the Soviet Union, this approach to geopolitics turned out to have huge strategic benefits for America.

Indeed, the fact that this strategy worked in the decades after World War II is precisely our problem today. The wealth-creation engine of the post-war world was designed in America, but available to other nations too — and so in time those that had more advanced economies before the war (predominantly Western Europe and Japan) re-industrialized to the point that, by the 1970s, they began to challenge America’s position. This revived competition, along with the oil shocks of the ’70s, dramatically changed the global circumstances that had allowed the United States to have it all: high rates of economic and wage growth along with a high degree of economic equality.

Ronald Reagan’s solution to the ’70s crisis proceeded from two diagnoses. The first was that macroeconomic pump-priming was merely creating inflation, not growth. The second was that America’s economy had large untapped potential for growth, but that this potential went unrealized because of the restrictions on markets intended to promote social harmony as part of the post-war economic consensus. These included everything from price controls to government encouragement of private-sector unionization to zealous anti-trust enforcement. Reagan’s strategy, therefore, was to promote sound money plus deregulation. He succeeded, and America re-emerged as the acknowledged global economic leader. Economic output per person is now 20 to 25% higher in the U.S. than in Japan and the major European economies, and America’s economy dominates the world in size and prestige.

But it is important to see that this robust growth means only that America has not lost ground in global economic competition, not that it has gained much. From 1980 through today, America’s share of global output has been constant at about 21%. Europe’s share, meanwhile, has been collapsing in the face of global competition — going from a little less than 40% of global production in the 1970s to about 25% today. Opting for social democracy instead of innovative capitalism, Europe has ceded this share to China (predominantly), India, and the rest of the developing world. The economic rise of the Asian heartland is the central geopolitical fact of our era, and it is safe to assume that economic and strategic competition will only increase further over the next several decades.

It is common to think of the post-war global economy as a baseline of normalcy to which we wish to return. But it seems more accurate to see that era as an anomaly: the apogee of relative global economic dominance by the West, and by the United States within the Western coalition. The hard truth is that the economic world of 1955 is gone, and even if we wanted it back — short of emerging from another global war unscathed with the rest of the world a smoking heap of rubble — we could not have it.

Yet the strategy of giving up and opting out of this international economic competition in order to focus on quality of life is simply not feasible for the United States. Europeans can get away with it only because they benefit from the external military protection America provides; we, however, have no similar guardian to turn to. We do not live in a Kantian world of perpetual commercial peace. Were America to retreat from global competition, sooner or later those who oppose our values would become strong enough to take away our wealth and freedom.

A HOUSE DIVIDED

If the pain of innovation calls for some mitigation of its effects, but the demands of global competition require that we not unduly stifle innovation, clearly some balance must be found. The task of striking such equilibrium, however, is made far more difficult by the internal deterioration of our society — which harms both our ability to compete and our capacity for social cohesion.

Of the many social and cultural changes that have rocked American society over the past half-century, the most relevant to the state of our political economy today may be the growing bifurcation of America. Increasingly, our country is segregated into high-income groups with a tendency to bourgeois norms, and low-income groups experiencing profound social breakdown.

This breakdown did not happen overnight. Longstanding academic and avant garde attacks on traditional social norms exploded into a political and popular movement identified with the left in the 1960s. In the ’70s, American attitudes and behavior began to change on a mass scale. This cultural shift naturally stimulated a response in defense of tradition from the right. At the time, it was often characterized as a call for “law and order” — but this pushback also incorporated resistance to evolving sexual mores and gender roles, to racial equality, and to the decriminalization of drugs and other activities previously considered anti-social.

This resistance movement — which in a sense came to power with the Nixon administration — was clearly concerned with questions of social cohesion and stability, even to the point of implementing highly interventionist economic policies directed to such concerns. (The wage and price controls Nixon imposed on much of the economy are proof enough of that.) But others on the right disagreed, arguing that the natural ally of traditional morality was libertarian economics, and vice versa, because long-term economic success rested on a foundation of traditional cultural mores. An important part of Ronald Reagan’s political genius was his determination to unite social and economic conservatives behind this integrated vision, making them key components of a governing coalition by the time he became president in 1981.

But while conservatives could make a strong case for the notion that cultural stability and cohesion were essential to economic growth, most preferred to ignore the opposite side of the coin: the worry that economic dynamism was harmful to social cohesion. And in the 1990s, a neutral observer could have been forgiven for believing that, despite the economic successes of the 1980s, the cultural foundations of democratic capitalism were collapsing. Crime rates, illegitimacy, drug use, and many other measures of social dysfunction were all on the rise, seemingly without limit.

Fortunately, starting later in that decade and continuing through today, America seems to have renormalized to some degree. Many of these trends — particularly the spike in crime — reversed course.

The new normal, however, is different from the old normal. To begin with, certain strands of the old bourgeois consensus have frayed, and others have simply disappeared, at least for some parts of the population. The wealthier and better-educated segments of our society, for example, have re-established the primacy of stable families and revived their ­intolerance of crime and public disorder. But they have combined this return to tradition with very non-traditional attitudes about sex, masculinity, and overt piety.

More important, while affluent and educated Americans are returning to the traditional family model, the poor and less educated are not. The gap between rich and poor today is also a gap in cultural norms and mores to a degree unparalleled in our modern experience. The overall divorce rate, for example, exploded in the 1970s, but has since returned to just about its 1960 level for those with a college education. For the less educated, however, the rate has continued to climb — and women without high-school diplomas are now about three times as likely to divorce within ten years of their first marriage as their college-educated counterparts.

Child-rearing has seen a similar split. In 1965, almost no mothers with any level of education reported that they had never been married. Today, this still holds true for mothers who have finished college: Only 3% have never been married. But that figure stands in stark contrast with the nearly 25% of mothers without high-school diplomas who say that they have never been married. In fact, last year, about 40% of all American births occurred out of wedlock. And about 70% of African-American children — as well as most Hispanic children — are born to unmarried mothers. But this situation obtains for low-wage, non- college- educated whites as well: It is estimated that about 70% of children born to non-Hispanic white women with no more than a high-school education and income below $20,000 per year were born out of wedlock.

The level of family disruption in America is enormous compared to almost every other country in the developed world. Of course, out-of-wedlock births are as common in many European countries as they are in the United States. But the estimated percentage of 15-year-olds living with both of their biological parents is far lower in the United States than in Western Europe, because unmarried European parents are much more likely to raise children together. It is hard to exaggerate the chaotic conditions under which something like a third of American children are being raised — or to overstate the negative impact this disorder has on their academic achievement, social skills, and character formation. There are certainly heroic exceptions, but the sad fact is that most of these children could not possibly compete with their foreign counterparts.

As the lower classes in America experience these alarming regressions, wealthier and better-educated Americans have managed to re-create a great deal of the lifestyle of the old WASP ascendancy — if with different justifications for it. Political correctness serves the same basic function for this cohort that “good manners” did for an earlier elite; environmentalism increasingly stands in for the ethic of controlling impulses so as to live within limits; and an expensive, competitive school culture — from pre-K play groups up through graduate school — socializes the new elite for constructive competition among peers. These Americans have even re-created the old WASP aesthetic preference for the antique, authentic, and pseudo-utilitarian at the expense of vulgar displays of wealth. In many cases, they live in literally the same homes as the previous upper class.

Such behavior enables multi-generational success in a capitalist economy, and will serve the new elite well. But what remains to be seen is whether this new upper class will have the nerve, wit, and sense of purpose that led the old WASP elite to develop a social matrix that offered broadly shared prosperity to generations of Americans.

Their task will be made very difficult by the growing bifurcation of social norms in America. A welfare state can best perform its basic function — buffering the human consequences of the market, without unduly hampering its effectiveness — where enough widely shared social capital exists to guide the behavior of most people in a bourgeois direction. But as it performs that function, the welfare state creates incentives that push people toward short-term indolence, free riding, and self-absorption — thus undermining the very norms, and consuming the kind of social capital, it needs to operate. (The market often does the same thing: relying on rules and behaviors made possible by traditional morality even as it undercuts it.)

Post-war America had much more widely shared bourgeois norms, and so was better able to contend with the negative side effects of the welfare state. Today’s American underclass, however, is increasingly developing in the absence of such norms — to a large degree as the result of the welfare state itself. Meanwhile, the need for innovation and the pressures of a global economy only continue to reinforce the causes of our social bifurcation.

INEQUALITY AS SYMPTOM

Perhaps the best illustration of these pressures — to innovate and deregulate without coming apart at the seams — is found in widening economic inequalities. It has often been noted that American society has become increasingly unequal in economic terms over the past 30 years. As Federal Reserve chairman Ben Bernanke noted in a 2007 speech, “the share of income received by households in the top fifth of the income distribution, after taxes have been paid and government transfers have been received, rose from 42% in 1979 to 50% in 2004, while the share of income received by those in the bottom fifth of the distribution declined from 7% to 5%. The share of after-tax income garnered by the households in the top 1% of the income distribution increased from 8% in 1979 to 14% in 2004.” A typical senior partner in a high-end investment-banking, corporate-law, or management-consulting firm can now expect to make upwards of $1 million per year. In the stratosphere of the economy, the increases in wealth have been mind- boggling: Even after the recent market meltdowns, there are about 30 times as many American billionaires today as there were in 1982.

The growth in inequality that began in the 1970s was driven by the social and economic forces outlined earlier. In 1970, “non- distributive services” (finance, professional services, health care, and so on) became for the first time a larger part of the private economy than goods- producing industries. This shift to services tended to enhance the prospects of the cognitive elite at the expense of traditional industrial workers. At the same time, as we have seen, the combination of changes in cultural mores and the growth of social programs began to disassemble the traditional family — ultimately leading to a class-based divide in family structure, which privileges the better-educated Americans already reaping the benefits of the shifting economy. The social capital transmitted by intact families has therefore become a more and more relevant source of competitive advantage.

Two exogenous shocks were also important. First, American domestic production of oil peaked in 1971; oil imports doubled between 1970 and 1975; and OPEC was able to drive large price increases. This oil shock was directly regressive, but it also tended to disproportionately harm those industries that were the source of high-wage union jobs. Second, the percentage of the U.S. population born abroad — which had reached its historical minimum in 1970 — began to rise rapidly as mass immigration resumed after a multi-decade hiatus. This development increased inequality further by introducing a large low-income group to the population, and by intensifying wage competition among lower-skill workers.

The Reagan economic revolution exacerbated the problem. Its success resulted, in part, from forcing extremely painful restructuring on industry after industry. One critical consequence of this restructuring was a new compensation paradigm — one that relies on markets rather than on corporate diktats, regulation, or historical norms to set pay. This new regime also accepts a much higher degree of income disparity based on market-denominated performance, and it expects that most people will exploit the resulting demand for talent by moving from company to company many times during a career. Growing inequality was a price we paid for the economic growth needed to recover from the ’70s slump and to retain our global position.

Rising inequality would have been easier to swallow had it been merely a statistical artifact of rapid growth in prosperity that substantially benefited the middle class and maintained social mobility. But this was not the case. Over the same period in which inequality has grown, wages have been stagnating for large swaths of the middle class, and income mobility has been declining.

Evaluating the real change in economic circumstances of a typical American family over the past 30 years is extremely complicated. To begin with, the typical family is smaller than it was three decades ago. Further, how we adjust for inflation has an enormous impact on any comparative calculations. Finally, family budgets must increasingly account for previously unpaid work — like child care, or attending to sick relatives.

Despite these complicating factors, a few trends still emerge rather clearly. First, average living standards have continued to rise since 1980. Second, the real hourly wages for a typical non-supervisory job have not increased very much over this period. Third, this wage stagnation is at least partly explained by the rising costs of health care — which, because of the American system of employer-based health insurance, are usually deducted implicitly from what workers see as wages. Fourth, personal indebtedness has risen dramatically over the same period and accelerated rapidly during the past decade — so that at least some of the increased consumption was simply borrowed. And last, income mobility — the likelihood of an individual’s moving up the relative income distribution — appears to have declined slightly over the past three decades, according to multiple studies by the Federal Reserve Banks of Boston and Chicago.

Furthermore, the divisive effects of this cluster of trends — rising income inequality and reduced income mobility, some degree of middle-class wage stagnation, increased personal debt, and increased class stratification of stable social behavior — are only intensified by climbing rates of assortative mating and residential segregation, as well as an increasingly crude and corrosive popular culture combined with the technology-driven fragmentation of mass media.

So economic inequality is likely to cause problems with social cohesion — but far more important, it is a symptom of our deeper problem. As the unsustainable high tide of post-war American dominance has slowly ebbed, many — perhaps most — of our country’s workers appear unable to compete internationally at the level required to maintain anything like their current standard of living. And a shrinking elite portion of the American population, itself a shrinking fraction of the world ­population, cannot indefinitely maintain our global position.

We are between a rock and a hard place. If we reverse the market-based reforms that have allowed us to prosper, we will cede global economic share; but if we let inequality and its underlying causes grow unchecked, we will hollow out the middle class — threatening social cohesion, and eventually surrendering our international position anyway. This, and not some world-is-flat happy talk, is what the challenge of globalization means for America. But unfortunately, by a combination of carelessness and design, we appear now to be embracing a counterproductive response to this daunting dilemma.

TOWARD SOCIAL DEMOCRACY

The past year, spanning the final months of the Bush administration and the opening months of the Obama administration, has produced a stunning transformation of America’s political economy. The first major initiative of the new president and Congress was the artfully labeled stimulus bill, which will have the federal government spend nearly $800 billion over the next ten years — less than 15% of it in fiscal year 2009. More than a short-term emergency measure, the stimulus represents a medium-term transformation of the character of federal spending — and government action — in America.

Only about 5% of the money appropriated is intended to fund things like roads and bridges. The legislation is instead dominated by outright social spending: increases in food-stamp benefits and unemployment benefits; various direct and special- purpose spending relabeled as tax credits for renewable-energy programs; increased funding for the Department of Health and Human Services; and increased school-based financial assistance, housing assistance, and other direct benefits. The objective effect of the bill is to shift the balance of U.S. government spending away from defense and public safety, and toward social-welfare programs. Because the amount of spending involved is so enormous, this will be a dramatic material shift — not a merely symbolic gesture.

Meanwhile, the federal government has also intervened aggressively in both the financial and industrial sectors of the economy in order to produce specific desired outcomes for particular corporations. It has nationalized America’s largest auto company (General Motors) and intervened in the bankruptcy proceedings of the third-largest auto company (Chrysler), privileging labor unions at the expense of bondholders. It has, in effect, nationalized what was America’s largest insurance company (American International Group) and largest bank (Citigroup), and appears to have exerted extra-legal financial pressure on what was the second-largest bank (Bank of America) to get it to purchase the country’s largest securities company (Merrill Lynch). The implicit government guarantees provided to home-loan giants Fannie Mae and Freddie Mac have been called in, and the federal government is now the largest de facto lender in the residential real-estate market. The government has selected the CEOs and is setting compensation at major automotive and financial companies across the country.

On top of these interventions in finance and commerce, the administration and congressional Democrats are also pursuing both a new climate and energy strategy and large-scale health-care reform. Their agenda would place the government at the center of these two huge sectors of the economy, sacrificing some economic vitality for public control. The latter program would also create an enormous new federal entitlement.

All told, finance, insurance, real estate, automobiles, energy, and health care account for about one-third of the U.S. economy. Reconfiguring these industries to conform to political calculations, and not market-driven decisions, is likely to transform American economic life. And the fiscal consequences of the spending involved will be enormous. The federal budget deficit for 2009 was about 11% of gross domestic product, which is far higher than any the United States has experienced since World War II. This deficit spending is the real stimulus. Something like 10% of all the economic demand in the United States is supported by government borrowing from the future, which is essential to propping up the current “recovery.” Even more important, the Congressional Budget Office projects that existing laws will now lock in a structural budget deficit of more than 3% of GDP every year for the foreseeable future. And this assumes we will escape the current global economic situation without further financial catastrophe (and that America won’t be forced into a war or other unanticipated major contingency over the next several decades). The CBO states flatly that this long-term budget path is “unsustainable.”

The basic character of America’s financial position is changing before our eyes. One year ago, federal government debt held by the public was 41% of GDP. Today, it is about 54% of GDP. The CBO projects that it will approach 70% of GDP by 2020, which is a level not seen since the immediate aftermath of World War II. Unless expenditures are reduced or taxes are raised, this debt will continue to accumulate indefinitely — until we reach the point at which we can no longer find enough lenders to simply roll it over. At that moment, Americans will face exactly three choices: raise taxes, default on debt, or devalue the currency. The most likely outcome is higher taxes, probably including a value-added tax (VAT) — essentially the equivalent of a national sales tax — as it would be hard to find another method that could collect enough revenue to keep our debt under control.

Seen together, these initiatives — shifting government spending away from defense and public safety toward social programs; deeper direct involvement of the government in the operation of large corporations across a substantial portion of the economy; energy rationing in the name of managing climate change; more direct government control of health-care provision; and higher tax rates that probably include a VAT — point in a clear direction. The end result would be an America much closer to the European model of a social-welfare state, which prioritizes cohesion over innovation.

Of course, the European model is not an inherently terrible way to organize human society. It is, however, a model very poorly suited to America’s current strategic situation, and would leave us in a far worse position to deal with the challenge of balancing innovation and cohesion. We do not have the luxury of drowning our sorrows in borrowed money while watching our power and influence wane.

America’s challenge is more serious than that: How do we continue to increase the market orientation of the American economy, while helping more Americans participate in it more fully?

A NEW APPROACH

It won’t be easy. But along with taking steps to better balance America’s government finances and reform our entitlement system, several preliminary ideas can help guide our thinking as we confront, at last, the reality of America’s circumstances.

To begin with, we must unwind some recent errors that fail to take account of these circumstances. Most obviously, government ownership of industrial assets is almost a guarantee that the painful decisions required for international competitiveness will not be made. When it comes to the auto industry, for instance, we need to take the loss and move on. As soon as possible, the government should announce a structured program to sell off the equity it holds in GM. Similarly, the federal government should relinquish direct control of banks and insurance companies. Moreover, one virtue of the slow rollout of spending under the stimulus bill is that most of it can be stopped — and should be. Any programs that have been temporarily increased under the terms of the law should be forced back down to pre-stimulus levels, and attempts to make the increases permanent should be resisted in the absence of a sustainable fiscal regime. Avoiding economically extravagant cap-and-trade legislation and, to the extent possible, a government takeover of health insurance would also help us avoid unforced errors.

Second, the financial crisis has demonstrated obvious systemic problems of poor regulation and under-regulation of some aspects of the financial sector that must be addressed — though for at least a decade prior to the crisis, over-regulation, lawsuits, and aggressive government prosecution seriously damaged the competitiveness of other parts of America’s financial system. Since 1995, the U.S. share of total equity capital raised in the world’s top ten economies has declined from 41% to 28%. We do not want the systemic risks of under-regulation, but we should also be careful not to overcompensate for them.

Regulation to avoid systemic risk must therefore proceed from a clear understanding of its causes. In the recent crisis, the reason the government has been forced to prop up financial institutions isn’t that they are too big to fail, but rather that they are too interconnected to fail. For example, a series of complex and unregulated financial obligations meant that the failure of Lehman Brothers — a mid-size investment bank — threatened to crash the entire U.S. banking system.

As we work to adapt our regulatory structure to fit the 21^st century, we should therefore adopt a modernized version of a New Deal-era innovation: focus on creating walls that contain busts, rather than on applying brakes that hold back the entire system. Our reforms should establish “tiers” of financial activities of increasing risk, volatility, and complexity that are open to any investor — and somewhere within this framework, almost any non-coercive transaction should be legally permitted. The tiers should then be compartmentalized, however, so that a bust in a higher-risk tier doesn’t propagate to lower-risk tiers. And while the government should provide guarantees such as deposit insurance in the low-risk tiers, it should unsparingly permit failure in the higher-risk tiers. Such reform would provide the benefits of better capital allocation, continued market ­innovation, and stability. It would address some of the problems of cohesion by allowing more Americans to participate in our market system without being as exposed — or unwittingly exposed — to the brutal effects of market collapses. It would also help get the government out of the banking business and preserve America’s position as the global leader in financial services without turning our financial sector into a time bomb.

Third, over the coming decades, we should seek to deregulate public schools. It would be foolish to imagine that we can simply educate everyone in America to be globally competitive. In a nation where about 40% of births occur outside of wedlock, many children will be left behind. Nonetheless, schools remain one of our primary policy instruments for enhancing both social mobility and our competitive position. They are essential to the task of balancing innovation and cohesion. To function effectively, though, America’s schools need to be improved dramatically. Our basic model of public schooling — accepting raw material in the form of five-year-olds, and then adding value through a series of processing steps to produce educated graduates 12 (or more) years later — reflects the vision of the old industrial economy. This worked well in an earlier era, but improvements that might have kept this model up to date have been stalled for decades. We now need a new vision for schools that looks a lot more like Silicon Valley than Detroit: decentralized, entrepreneurial, and flexible.

For a generation, many on the right have argued for school choice — especially through the use of vouchers — as the primary means of achieving this vision. Their approach, however, has been both too doctrinaire and too artificial. If school choice ever becomes more than tinker-toy demonstration projects, taxpayers will appropriately demand that a range of controls and requirements be imposed on the schools they are ultimately funding. At that point, what would be the difference between such “private” schools and “public” schools that were allowed greater flexibility in hiring, curriculum, and student acceptance, and had to compete for students in order to capture funding? Little beyond the label.

We should pursue the creation of a real marketplace among ever more deregulated publicly financed schools — a market in which funding follows students, and far broader discretion is permitted to those who actually teach and manage in our schools. There are real-world examples of such systems that work well today — both Sweden and the Netherlands, for instance, have implemented this kind of plan at the national level.

Fourth, we should reconceptualize immigration as recruiting. Assimilating immigrants is a demonstrated core capability of America’s political economy — and it is one we should take advantage of. A robust-yet-reasonable amount of immigration is healthy for America. It is a continuing source of vitality — and, in combination with birth rates around the replacement level, creates a sustainable rate of overall population growth and age-demographic balance. But unfortunately, the manner in which we have actually handled immigration since the 1970s has yielded large-scale legal and illegal immigration of a low-skilled population from Latin America. It is hard to imagine a more damaging way to expose the fault lines of America’s political economy: We have chosen a strategy that provides low-wage gardeners and nannies for the elite, low-cost home improvement and fresh produce for the middle class, and fierce wage competition for the working class.

Instead, we should think of immigration as an opportunity to improve our stock of human capital. Once we have re-established control of our southern border, and as we preserve our commitment to political asylum, we should also set up recruiting offices looking for the best possible talent everywhere: from Mexico City to Beijing to Helsinki to Calcutta. Australia and Canada have demonstrated the practicality of skills-based immigration policies for many years. We should improve upon their example by using testing and other methods to apply a basic tenet of all human capital-intensive organizations managing for the long term: Always pick talent over skill. It would be great for America as a whole to have, say, 500,000 smart, motivated people move here each year with the intention of becoming citizens.

FACING THE FUTURE

These broad proposals are, of course, mostly ways to stop digging our hole even deeper. At the moment, that would be no small achievement — since we are moving toward a model of social democracy that is likely to dim our long-term prospects.

But more important than these particular steps is the imperative to see our problem clearly, and to shape our political and economic arguments around it in the coming years. An America that wants to keep its global edge cannot afford to neglect the necessity of innovation and growth, or to ignore the necessity of social cohesion and stability. For the moment, the former of these is in special need of defense — since the party in power seems inclined to sacrifice economic dynamism for its vision of social justice. Eventually, however, the challenge of preserving the moral fabric and social unity of America may prove the more difficult problem. Strong families — and the commitments and habits they teach — are essential to both a market economy and a working democracy. More than ever before, the health of America’s social institutions must be a priority for all those concerned about our country’s future — and especially those who would champion innovation and free markets.

Balancing economic innovation and social cohesion is the challenge of every free nation today — but it is a particularly pressing challenge for the special nation that holds in its hands so much of the fate of democracy and capitalism in our world.

Jim Manzi is the founder and chairman of an applied artificial intelligence software company, and a senior fellow at the Manhattan Institute.

Moscow

Just before Christmas in 1997, as a tumultuous stock-market crisis ravaged emerging markets in every corner of the globe, readers of the Wall Street Journal were treated to some good news: Russia was going to emerge from the mess unscathed. While conceding that “few debt markets outside Southeast Asia were hit harder by recent financial turmoil than Russia’s,” the Journal’s Moscow bureau chief, Steve Liesman, added quickly that “many analysts believe an equally strong rebound may be in the offing.” Moreover, Liesman wrote, investors were rapidly coming to the realization that “Russia’s problems are far different and, for the moment, less dire than those that undermined Asian economies.” The December 16 piece was headlined, “Russian Debt Markets Due for Rebound.”

A few weeks later, Liesman and the Journal used even stronger language to trumpet Russia’s economic merits. They chided investors who were too busy “fretting over Asia’s financial crisis” to notice what they called “one of the decade’s major economic events: the end of Russia’s seven-year recession.”

The Journal’s prediction was more than a little precipitate. Instead of getting better, things in Russia got worse. A lot worse. Nine months after Liesman declared that Russia’s debt market was due for a rebound, and just over seven months after proclaiming the end of the Russian recession, the Journal–like most US newspapers–found itself having to explain the near-total collapse of Russia’s economy and capital markets.

What is most astonishing is not how badly Liesman and the Journal misreported one of the most tragic economic stories of the decade as it was happening. The amazing thing is that they won a Pulitzer Prize for their reporting of the Russian crisis after the country had gone down in flames. Liesman, who left the Moscow bureau in April of 1998 to return to New York, was called back to Moscow after the crisis to help write a series ofJournal pieces on how the Russian financial collapse happened. These articles completely contradicted the body of work he had left behind, leaving the impression that the collapse had been inevitable all along.

While it’s true that throughout the mid-nineties nearly the entire Western press corps had painted a similar picture of allegedly successful, if bumpy, market reform in Russia, the Wall Street Journal’s version was even more deluded, and more inappropriately enthusiastic, than the competition’s. Furthermore, few if any of those other outlets, with the possible exception of the New York Times, have as much influence internationally as theJournal. And none of those other reporters won the Pulitzer Prize. To win that, the Journal ought to have been ahead of the pack throughout; as it was, the paper’s coverage only stood out as the most spectacular wreck in a huge pileup.

Liesman’s Russia coverage was a case study in the kind of narrow colonialism and provincialism that is increasingly pervasive in American foreign news reportage. Until the crisis struck, Western reporters based in Moscow focused almost exclusively on the Russia story in terms of its relevance to Western businessmen–and as long as the stock market was doing well, and companies like British Petroleum were still proudly announcing mergers with Russian partners, much of the corruption that eventually sank the Russian economy was ignored. As a result, an event like the recent Bank of New York debacle actually came as something of a surprise to Americans. But for ordinary working Russians, a great many of whom have been watching their bosses send company money offshore for years while their own salaries go unpaid, the only surprise in the New York money-laundering story was that it didn’t come out sooner. And one reason it didn’t is that the Western press, particularly pro-”reform” cheerleaders like the Journal, was plainly uninterested, until it was far too late, in making an effort to see the corruption that was a daily reality for the majority of Russians.

In fact, until the crisis forced them to change their tune, Western reporters like Liesman seemed to distrust reports of widespread public despair over the Yeltsin regime’s criminal policies, preferring instead to rely upon the stock market, the pronouncements of the IMF and the results of Russian state-produced macroeconomic reports to tell them how the Russian economy was doing. As journalists Matt Bivens and Jonas Bernstein wrote in an article in the academic journal Demokratizatsia, which criticized Western press performance (including that of the Wall Street Journal) in post-Communist Russia: “Sadly, there is another dynamic at work here, an element of disdain for the Russians as a people…. [Many] Westerners have sympathy for the idea that following centuries of oppression, the Russians ‘aren’t ready’ to be trusted with complete democracy. Perhaps, then, it is better to let former Vice Premier Anatoly Chubais and his Harvard-trained whiz kids manipulate matters–always, of course, ‘in the larger interest.’”

Liesman, 36, a bombastic, balding New Yorker whose amateur blues band played a few coolly received gigs in Moscow clubs in his early years here, is still well known in the Moscow press corps as a sort of caricature of a typical Moscow-based US correspondent–a loud presence at press conferences and a knee-jerk anti-Communist. Despite having lived in Russia since 1992, when he came to work for the English-language Moscow Times, Liesman was still using a translator in 1998, the year he left.

“I wasn’t the only guy who was [working with a translator],” he said. “A lot of guys were doing that.” When reminded that he was the only one of those “guys” who had won the Pulitzer Prize, he conceded, “Well, that’s a point.”

Like many of the more linguistically challenged members of the foreign press corps in Moscow, Liesman fell into the classic trap of making one small group of English-speaking Russian politicians his most trusted source of information. That clique–including privatization czar Chubais, early Prime Minister Yegor Gaidar and allies of theirs like onetime property chief Maxim Boycko–was often referred to by Russia observers as the “St. Petersburg Mafia” (most of the group came from the northern capital). This group sold itself to the Western press as the vanguard of the anti-Communist, pro-Western movement and nudged reporters like Liesman into portraying any criticism of their policies as aid to the Communist movement.

Liesman’s unwillingness to report any negative news associated with the St. Petersburg Mafia first became glaringly obvious in early 1996, when he called privatization “the most successful and important of Russia’s reforms.” Part of the privatization effort that Liesman praised, the notorious “loans-for-shares” auctions, had just created a national scandal due to their overt criminality; it had forced loans-for-shares architect Chubais out of government. In these auctions of huge stakes in key Russian enterprises, Kremlin insiders decided the winners in advance, often helping out by padding their bids with government funds. These auctions instantly created a super-rich clique of monopolist “robber barons”–many of whom were much-vilified names in the US press this past summer, when they began appearing in connection with investigations into the Bank of New York scandal.

The criminality of these auctions was well detailed in the Russian- and English-language press: Izvestia, for instance, reported that $50 million in Ministry of Finance funds had been transferred to Bank Menatep before the latter won a huge stake in the oil company Yukos, and more than one paper noted the curious anomaly of two banks (Stolichny Bank and Menatep) guaranteeing each other’s bids in a “competitive” auction for a stake in the oil company Sibneft. The winning bid in that auction was just $100.3 million, despite the fact that the company, which at the time produced more than 22 million tons of crude per year, was clearly worth a lot more. Most observers at the time believed that the sweeping victory by the Communists in the 1995 parliamentary elections was at least partly fueled by public disgust over these bogus auctions. And every sane observer recognized that the auctions represented a profound step away from the Western capitalist model. Even the cautiously neoliberal Moscow Times criticized the auctions in a December 30, 1995, editorial: “As more than one commentator has said, this isn’t capitalism as the country ought to know it…. While it goes on, and there is no reason to think that it will stop, economic growth will be held back, and cronyism and cartels will prevent meritocracy and open markets.”

Liesman didn’t see it that way. His Journal coverage ignored the auctions’ reported improprieties and dismissed their critics as Communists and political malcontents. In a February 7, 1996, article, for instance, he compared the criminal investigations into loans-for-shares to “show trials”: “The [investigations] are at least partly political…. Some in Moscow’s financial circles even anticipate show trials that would sacrifice a few privatization deals to mollify the opposition and save the rest of the program.” In an interview for this article, Liesman said he believed, and still believes, that loans-for-shares was, relatively speaking, a success–or at least preferable to the alternatives. “It’s in your opinion that [loans-for-shares] wasn’t successful,” he said. “To me, if you ask me, what was the alternative? Keeping it in state hands?” Liesman added, “Do I stand accused of being on the Chubais bandwagon? If so, I plead guilty. Just like the United States government, and just like every other expert we spoke to.”

Unfortunately, none of the “experts” Liesman spoke to were ever very interested in advertising Russia’s problems to the Western investors who read his paper. Ultimately, this was the key to the Journal’s failure. While Western businessmen on the ground in Moscow saw the disaster of the Russian state in action–evident in their mass flight from Russia’s capital markets beginning in late 1997–Journal readers abroad were taken completely by surprise when catastrophe struck. As late as June 1998, when Russia’s capital markets teetered on the edge of collapse and worker protests over nonpayment of wages paralyzed rail travel across the country, the Journal was still dismissing Russia’s troubles as fallout from a few logistical glitches. In a June 5 article, Liesman argued that the crisis had its roots at least partially in a scheduling blunder by one of then-Prime Minister Sergei Kiriyenko’s underlings:

Moscow–In the story of how Russia’s markets collapsed in May, give at least a couple of paragraphs to a simple mistake by a provincial government aide.
It happened that Lawrence Summers…requested a meeting with Prime Minister Sergei Kiriyenko. But an aide to the youthful new prime minister…knew only that this Mr. Summers was a deputy secretary of the treasury–a title unworthy of an audience with a Russian prime minister.
Word leaked out that the two had failed to meet…. Over the next two weeks, a bad situation worsened, as ruble-holders rushed to convert to dollars, stock prices plunged, and a near panic brought Russia to the brink.

At the time this article was written, Russia was experiencing major unrest. The last remaining investors were pulling out en masse, markets were collapsing and the debt bubble had grown so large that no new IMF loan could possibly save it. But Liesman, apparently eager to reassure his readers, attributed May’s financial tremors mainly to PR gaffes–as well as the Asian financial crisis:

Until the most recent troubles in Asia–riots in Indonesia, more evidence of Japan’s deep ennui, a nuclear race on the Indian subcontinent–Russia appeared to have escaped the ravages of the Asian monetary maelstrom. Its notoriously poor tax collection was improving. Economic data showed growth for the first time in seven years. Credit Suisse First Boston declared the country a buy. Boris Jordan, an American who has become one of the biggest players in Russia’s stock market, went on vacation to Disney World.

Two things bear mentioning here. One is that before the crash, pro-reform journalists like Liesman often justified placing a positive spin on the Russian economy by noting that their sources in places like Credit Suisse were constantly pumping up Russia as a hot market. The brokers, the thinking goes, were the experts–so how could a reporter be remiss by trusting them? Answer: very easily. Any good business reporter knows that few stock analysts or brokers in emerging markets will go on the record as saying anything negative about their host country’s economies–because if they do, no one will buy into its market. Asking a Credit Suisse trader in Moscow to be straight about the Russian market is like asking a Ford dealer to compare a Taurus with a Lexus honestly. Quoting analysts is fine to get the bright side of a story, but a responsible reporter looks for hard economic data for balance–and this is what was consistently missing from the Journal’s coverage.

The second fact worth mentioning is that the Russian State Statistics Committee was notoriously unreliable. In fact, its chief, Yuri Yurkov, was fired for fudging statistics shortly after Liesman’s June article appeared, news that went largely unreported in the Western press. In contrast, when the much-vilified anti-IMF president of Belarus, Alexander Lukashenko, announced a 10 percent rise in GDP for 1997, the news was greeted with widespread skepticism in the West. A Moscow Times story, for instance, was headlined “Belarus Growth a Question of Statistics” and speculated that Lukashenko might be “cooking the books.” Russia got no such treatment in the reform era. The most revealing passage in the June article by Liesman was the line about Disney World. Thousands of people were sitting on train tracks to beg for their wages, and Liesman was writing about one rich American’s plans to travel to Disney World.

Then again, lack of empathy for the plight of ordinary Russians was a consistent feature not only of Liesman’s coverage but of US policy toward Russia in general. Like the IMF and the World Bank, both of which felt that Russia’s need to pay their high-priced consultants was greater than its need to pay many of its “economically unnecessary” workers, Liesman revealed a concern for wage-earning Russians that extended only as far as their perceived utility in the service of global capitalism. When asked why he hadn’t covered the nonpayment crisis, he replied: “Yeah, but nonpayment for what kind of labor?”

Mining coal?

“Coal that was needed, or not needed?” he snapped.

In that same June 5 article, Liesman also suggested that Russia might have been better off if it had been more corrupt, not less. “Another policy change also hurt,” he wrote. “For years, the government had used commercial banks to pay its bills. Last year, it moved to a US-style treasury system, with branches of its own. The change saved money, reduced corruption and made payments more timely. But an unforeseen result was a fall in the cash moving through banks–money that these banks once used to play the government bond market.

“So when the crunch hit, the Russian banks couldn’t help.”

Liesman wasn’t the only major-market bureau chief to blow the Russia story. The Washington Post and the Los Angeles Times both described Chubais as a “lightning rod” for unfair criticism when he was fired, downplaying or ignoring the many scandals he’d been linked to. Business Week wrote a glowing profile of banker Vladimir Potanin after he had been linked to an apparent bribe of officials in charge of a major auction Potanin had just won. In fact, most of the Western press, like the US government, got the Russia story wrong before the crash; as Liesman said, most of them really were on the Chubais/reform bandwagon right up until the August crash, when the position became untenable. In a 1995 article for the New York Times, John Lloyd, onetime Moscow bureau chief of London’s Financial Times, dismissed as “facile pessimism” claims that Russia was sinking into a quagmire. Like Liesman, he would eventually change his tune, writing a much-ballyhooed eulogy of the Russian reform effort in the New York Times Magazine this past summer that railed theatrically against the corruption in the Yeltsin regime. In that article Lloyd even denounced the loans-for-shares auctions as acts of “colossal criminality”–language far stronger than he had ever used when privatization was actually taking place.

Liesman was replaced by Andrew Higgins in July 1998, but he returned to Moscow in August to participate in the writing of a series of articles explaining how the crisis had unfolded. Apparently realizing he was on to a Pulitzer-caliber story, Liesman backed off every position he had taken in the previous two years and enthusiastically volunteered the new conventional wisdom: that the fundamentals for an Asia-plus meltdown had been there all along. In a prizewinning September 23 article co-written with Higgins, Liesman recounted grotesque anecdotes illustrating how Russia’s crony capitalism was one of the fundamental reasons behind the country’s collapse, concluding: “All the while, the government was going broke. It couldn’t collect the taxes it needed to pay its bills. So it built a rickety structure of domestic and foreign debt, creating the pyramid that collapsed in August and pushed Russia into default.”

What about loans-for-shares, which Liesman had lumped in with “the most successful and important of Russia’s reforms”? At the time, he had dismissed critics of the auctions as Communists. But in preparation for the Pulitzer ball, Liesman and Higgins sneered that only a fool could have missed the overt criminality of the auctions:

Desperate for cash, the government mortgaged some of its most lucrative assets for a fraction of their real value in return for loans from a handful of bankers. Meeting in secret, they carved up the spoils. Government bureaucrats colluded in the so-called loans-for-shares deals, allowing ownership of the stock-in-trust to be awarded at rigged auctions.
There wasn’t even a semblance of propriety. At a news conference in 1996, a Menatep executive could hardly contain his laughter when he claimed, implausibly, that he didn’t know who owned the subsidiary that had just bought Yukos, Russia’s second-biggest oil company. Russian journalists, served cognac by the bank’s staff, guffawed in disbelief. Menatep had run the auction and the bank, it would later disclose, controlled the firm that entered the winning bid.

None of the above, or even a hint of it, was in Liesman’s coverage of loans-for-shares when the story first happened. And none of it was new news.

Pulitzer candidates, like defendants in murder trials, are ostensibly judged by what they did, not by who they are–character and past behavior theoretically being irrelevant to the jury’s decision. In this case, Liesman, Higgins and the four other Journal staffers who won were judged by what they did in ten post-crisis articles, written between June and December of 1998.

But there are times when who a journalist is and what he does coincide. The record shows that Liesman’s bureau was little more than a PR conduit for a corrupt regime, consistently averting its eyes from the ugly truth. It cleaned up its act just in time to win the most coveted award in American journalism. The Pulitzer committee, as a body composed of journalism experts, either knew of the Journal’s past record and chose to ignore it, or was negligently unaware of the Journal’s body of work on Russia. If the former is true, it’s time to stop taking the Pulitzer Prize seriously as a standard-setter for the journalism profession. If the latter, the board should reconsider its award.

Letter From Kabul

What the United States Must Overcome in Afghanistan

Kim Barker
KIM BARKER is Edward R. Murrow Press Fellow at the Council on Foreign Relations.

Part I: Corruption

In his inauguration speech, Afghan President Hamid Karzai stressed the importance of the country’s fight against corruption and spoke of his commitment to ending “the culture of impunity and violations of law.” Afghans, however, reacted warily: they are waiting to see action, which has been in short supply in Afghanistan. Corruption has grown around Karzai like a fungus, touching almost every ministry and office. As Karzai begins his new term, this pervasive culture of graft is blamed for driving a wedge between Afghans and their government — even driving some toward the Taliban.

Western officials have demanded that the Afghan government take decisive action against corruption, but such pressure may be counterproductive. Karzai has grown increasingly resentful of Western criticism, both because such treatment comes across as disrespectful in Pashtun culture and because Karzai believes that standing up to the United States will make him more popular with Afghans. Pressuring Karzai too often simply pushes him into a defensive crouch.

In a television interview in early November, a week after his former challenger Abdullah Abdullah dropped out of the presidential race, effectively canceling the runoff, Karzai appeared vague about corruption inside his government and seemed to view it as a phenomenon inflicted from the outside. He blamed overseas interests for waste, saying that much of the country’s corruption stems from large contracts initiated by foreign governments and companies. “For that sort of corruption, it’s the international community that also shares responsibility with us,” he said.

For Afghans, corruption falls into three categories: first is petty corruption by lower-level government employees who are looking out for their own survival. Next is large-scale corruption, which is committed by ministers and relatives of top Afghan officials involved in lucrative international contracts or the drug trade. Last is what Karzai described as Western-driven corruption, which begins with the foreign contractors who live conspicuously well in Kabul. They subcontract out work to local Afghans, who then make their own subcontracts with other Afghans. The end result is that the bulk of every aid dollar is wasted. But this, at least by Western standards, is technically legal — a seeming loophole that many Afghans find absurd, if not hypocritical and offensive.

Making the problem worse is that the Afghan government has few successful examples on which to model a fight against corruption. Karzai and other officials have called for the creation of an anticorruption court that would be similar to the country’s drug court — which has been ineffective at best, if not corrupt itself. The drug court has sentenced only a handful of major players; of those, Karzai pardoned several earlier this year, in a move that caused U.S. officials to pull their hair in frustration. And Mohammad Alim Hanif, one of the few reputedly clean judges on the court, was shot dead more than a year ago. His murder remains unsolved.

Corruption in the country has reached such a scale that Ashraf Ghani, a former World Bank executive and presidential candidate, says that a senior Karzai adviser told him that one government minister made $25 million in a single year, and a northern governor, $75 million. Two of Karzai’s brothers — Mahmoud Karzai and Ahmed Wali Karzai — and relatives of at least one governor, Gul Agha Shirzai, and the country’s defense minister, Abdul Rahim Wardak, have either earned money with questionable tactics or been awarded lucrative Western contracts with little fair competition. They have been helped by their relatives’ political clout and suspicious bidding practices.

Some of the shifting public support toward the Taliban is due to the fact that the Taliban, unlike the central government, seem to take such widespread corruption seriously. In 33 of the country’s 34 provinces, the Taliban has set up its own anticorruption committees, which allow local Afghans to complain about any injustice, including those inflicted by the Taliban. One Afghan official told me that such committees would be “a good idea” for the government. The Taliban also runs its own courts, which are known for quick justice without the need to pay bribes.

But for now, paying money remains the only way to efficiently accomplish anything with the Afghan government. Daniel Grey, the local head of a large U.S. contracting company that works on roads and power, said that his company refuses to pay bribes. As a result, its work is made more onerous and ultimately more expensive. In one case, the customs department held 13 vehicles for a year before releasing them. Another time, in Kandahar, when Grey’s company was trying to load supplies onto a helicopter that costs $16,000 an hour to operate, an Afghan official came over to say that the helicopter would have to be loaded somewhere else. That cost the company an hour of time, or $16,000. But the official just wanted a $100 kickback. “The cost of avoiding a bribe was much more than we ever would have paid for a bribe,” Grey said.

Government employees ask for the money with a smile and a rub of an index finger and a thumb. “Shirini?” they sometimes ask, using the Dari word for “sweets,” or maybe baksheesh, the word for “tip.” Abdul Rahim Chakari, who works at the Ministry of Information and Culture, admitted to me that he takes bribes. “Everyone is miserable,” he told me. “I am paid $75 a month. If I don’t get bribes, how am I supposed to live?” Just feeding himself and his family, he said, costs $200 a month.

The harsh economics of life in Afghanistan mean that many bribe takers feel no shame. A regional supervisor of the country’s traffic police told me that he received about $200 a month in salary. His rent was $100, food for his wife and three children cost $300, other expenses ran $100. In other words, his monthly expenses exceeded his salary by $200, necessitating the acceptance of bribes.

It is this sort of corruption — the local, petty kind rather than the millions taken by ministers — that causes Afghans to distrust their government. Safiullah Abidy, the 24-year-old manager of a cosmetics shop in Kabul, said that corruption “is the most dangerous and bad thing in the country,” adding that “it is the worst memory we have of the last eight years.”

So far, the government’s approach to fighting corruption has been almost laughable. In 2008, the country’s first anticorruption task force was dissolved because it had no teeth. It probably did not help that Izzatullah Wasifi, the task force’s first head, had been convicted of selling heroin in Nevada in the 1980s and then ran into personality problems with Karzai.

A second anticorruption task force was launched a year ago, just after the first disbanded. It was named the High Office of Oversight and Anticorruption (HOOAC), but like its predecessor, it also lacks effective enforcement ability — largely because of early complaints by then Attorney General Abdul Jabar Sabit, who himself was later accused of corruption.

As a result, when the HOOAC required senior officials to register their assets, only a handful complied, including Karzai and the interior minister. Most simply ignored the requirement without incurring any consequences, including Ismail Khan, a former warlord who is now minister for water and energy; Abdul Rashid Dostum, a notorious former commander now serving as army chief of staff; and many people on the president’s own staff. So far, the parliament has not responded to any of the office’s letters. “I guess they are afraid,” Ershad Ahmadi, the deputy of the HOOAC, told me. “Maybe there are some reasons.”

The HOOAC’s most notable success was the production of a five-minute documentary on corruption in the police force and in the courts, proof for cabinet ministers who continue to deny that corruption exists. The office has also managed to streamline certain government processes, thereby minimizing the avenues for petty corruption. For example, legally registering a vehicle used to take 51 steps, a month of work, and $40 to $60. A $400 bribe cut that process to three days. The HOOAC, however, has reduced the number of required steps, lowered the turnaround for a license to three days, and required payment only at an official bank.

But, just as with those involved in the country’s booming drug trade, no major official has been punished or convicted. With the Taliban threatening the stability of the government and the international community wavering on its commitment to the country, many bureaucrats are seeing this moment as potentially the last opportunity to take what they can.

It appears as if this period will not end as quickly as many in the West are hoping. At the end of November, Afghan Attorney General Mohammed Ishaq Aloko announced a corruption probe against current and former government officials, including two unnamed sitting government ministers. So far, Karzai has refused to sign an order that would strip these men of their ministerial immunity and allow them to stand trial.

Shinkai Karokhail, a member of parliament, told me that enforcement needs to start at the top, with prosecutions of high-profile figures. “If we really bring one big guy to justice, you will see how everyone will fix themselves,” he said. “Why were the Taliban so successful fighting corruption? They punished people, and they followed the laws.”

Part II: The Warlords

Afghans once derided President Hamid Karzai as a U.S. puppet. After all, he won his office with the backing of the United States and has depended on U.S. assistance to run the country. But as Karzai prepares to name his new cabinet, Afghans are beginning to fear that someone else is pulling the strings: namely, the country’s former warlords, who have undergone a political makeover to become what some call Afghanistan’s “power brokers.”

During the election campaign, Karzai made various promises to different warlords, most of whom gained power during Afghanistan’s fight against the Soviets in the 1980s, and now both Afghans and Western officials worry that Karzai will honor those pledges, signaling how he plans to run the country for the next five years and who will have his ear.

“Politically, it’s an opportunity for Mr. Karzai to become a statesman or an outcast,” said Ashraf Ghani, the former Afghan finance minister and World Bank executive who ran for president against Karzai. “If he goes with those brokers, both he and the country will be the losers.”

Karzai is known to be influenced by the people around him. If he nominates strongmen or their underlings, it will send a clear message to the West that Karzai is not serious about fighting corruption or winning the support of average Afghans through competent governance.

In 2001, when Karzai was named interim president of Afghanistan, he had no militia of his own and few followers. Muhammad Qasim Fahim — who succeeded Ahmed Shah Massoud as leader of the anti-Taliban Northern Alliance — controlled much of the armed forces. Another contingent of largely Uzbek fighters aligned with the Northern Alliance was led by Abdul Rashid Dostum, an opportunistic former warlord who had frequently switched sides over the years. In the west, Ismail Khan directed a sizable third faction of the alliance. Karzai had a complicated relationship with all of them — he was reliant on their support and favor to keep his hold on power.

The international community has been similarly dependent on the country’s warlords. To drive out the Taliban in late 2001, the United States largely relied on the support of various warlords. In the north and west, Northern Alliance commanders led the charge against the Taliban with the help of U.S. airstrikes. Gul Agha Sherzai, a Pashtun warlord, seized the southern city of Kandahar, aided by U.S. special forces. And Padshah Khan Zadran pushed the Taliban out of the eastern Paktia province with U.S. assistance.

Ghani said the rise of the so-called power brokers has brought about a de facto return of their rule during the Afghan civil war between 1992 and 1994, which turned Kabul into a giant shooting gallery. But now, Ghani told me, it is even worse, because their rule has the U.S. government’s seal of approval.

When I spoke to Karzai last December, he referred to the warlords as “thugs” and blamed the U.S.-led coalition’s initial support of them for leading to most of Afghanistan’s current problems. “They created militias of those people who had no limits to misbehavior and who were sent to people’s homes to search their homes, to arrest them, and to intimidate them,” he said. “This has to stop if you want to succeed. Only then we can begin to build the Afghan government.”

At some point, however, Karzai seems to have changed his mind. All attempts to set up some kind of truth-and-reconciliation commission for the warlords or to hold them accountable for past crimes or alleged human rights abuses — especially during the civil war — failed. And this past year, a massive drop in popularity forced Karzai to align himself with some of the most controversial warlords in order to win votes.

Karzai named Fahim, a powerful Tajik warlord who is one of the richest and most feared men in Afghanistan, as his first vice president — essentially reversing his decision five years earlier to drop Fahim as vice president due to Western pressure. (In a way, this was expected, considering that Fahim’s brother has been in business with Karzai’s brother for years, privatizing state-run companies and earning millions.)

At the same time, Karzai kept Karim Khalili, a former Hazara warlord, as his second vice president. He made promises to influential warlords such as Muhammad Mohaqeq, another former Hazara commander who has grown more powerful than Khalili and now runs a Hazara ethnic political party. Mohaqeq, who ran against Karzai for president in 2004, has said Karzai promised him five cabinet seats in return for his support.

Over the summer, Karzai reinstated Dostum as army chief of staff. Dostum has been accused of past atrocities such as overseeing the stuffing of hundreds of Taliban prisoners into shipping containers, then leaving them to die. Only the year before, Dostum had been suspended from the largely ceremonial position and forced to flee to Turkey over allegations that he stormed the home of a political rival, Akbar Bai, and threatened to kill him. In November, just after the runoff election was cancelled, Dostum returned to Kabul to claim his prize.

Earlier this month, I went shoe shopping in Kabul’s fanciest mall, the City Center, with Sher Mohammad, a key Dostum aide, and Amir Peramqul, one of Dostum’s former commanders and now a top deputy. Peramqul had draped the end of his turban across his mouth in order to disguise himself from other Afghans in the mall. Mohammad was crowing about Dostum’s success in delivering the Uzbek vote to Karzai. At just that moment, Mohammad told me, Dostum was meeting with Karzai to find out his reward. “Dostum has been promised 20 percent of seats,” he said, walking into various stores and asking to see their “diplomatic shoes.”

It is an especially remarkable turnaround considering that Karzai has always offered up Dostum as a sacrificial warlord, proof that the Afghan government could prosecute its former commanders. Any time the West wanted to make an example of a warlord, Karzai eagerly suggested Dostum, but the United States and others would balk, most likely because Dostum was seen as a key U.S. supporter.

A former Karzai aide told me confidentially that the Afghan government had wanted to try Dostum last year, after he threatened Bai. “It was the U.S. who opposed it,” the former Karzai aide told me, repeating something I had been told by several top Afghan government officials in 2008. “Because Dostum was an ally. It’s also the international community that has contributed to the revived power of these men.”

Today, most Western officials agree that they want the warlords gone — although NATO still has to rely on some of them for security in the provinces. One Western diplomat told me that no one wanted to see the return of the mujahideen — the Islamic fighters who opposed the Soviets in the 1980s — many of whom became Afghan warlords (whereas some foreign members of the mujahideen went on to form al Qaeda).

It appears that Karzai has made too many promises to too many people to be able to honor them all. “There are a lot of competing demands on him,” said Ershad Ahmadi, the deputy of the country’s anticorruption commission. Ahmadi described Karzai as “a good president in a bad country” and went on to tell me that Karzai should find some other way to grant tokens of prestige or power to the warlords. “Give them something else,” he said, suggesting a possible advisory role that would carry little actual responsibility. “Like the National Council of whatever, ‘Dignified Afghans.’”

Another possible solution — one that Western diplomats fear — is that Karzai will expand the cabinet from 25 ministers so that he can dole out all the promised seats. But just creating new positions may not satisfy all of Karzai’s constituencies. Shinkai Karokhail, a prominent female member of parliament, recalled how when the Uzbeks were once given the Ministry of Women’s Affairs slot in return for Uzbek support, they complained. “They said, ‘Why don’t you give us a ministry led by a man?’”

The West now appears to be minimizing its dependence on Kabul and instead trying to build up its influence on what is happening in the rest of the country. One senior Western military official told me that regardless of who Karzai appoints as ministers, the West may try to avoid the notoriously weak central government and establish ties with local leaders. “Can you win at the local level and ignore the central government?” he said. “In a way, that’s our strategy now.”

Part III: The Taliban

After 30 years of war, Afghans are accustomed to switching sides — a fact that the United States often uses to make the case for “flipping” some members of the Taliban. But Afghans typically switch to whichever side they perceive as winning, often meaning the one with the most guns, staying power, and money. In such an environment, rumors can take on the strength of facts, and they indicate which direction those on the fence may be leaning.

On a recent trip to Kabul, I heard some new and telling rumors. Hungry Taliban fighters were so confident that they ordered 150 kebabs from a restaurant in Kandahar; so brazen that they then ate their kebabs right there on the street. Other rumors claimed that the U.S.-led coalition and the Taliban were working in concert — the British were flying insurgents from the south to the north in helicopters, while U.S. soldiers and the Taliban fought together at night.

“The Taliban are also the American people,” said Popal Sadat, a 28-year-old manager in a company that sells concrete barriers to guard against bombs at U.S. military and diplomatic facilities in Afghanistan. “They work hand in hand.” I asked him to explain. After nine at night, he insisted, U.S. soldiers team up with the Taliban. He knew it was true, he said, because he saw it on television. This was not true; I checked with the station, Tolo TV. But that did not matter.

Although it is easy to dismiss such rumors as simple ignorance, they contain a truth that is damning to U.S. hopes of achieving success on a short timeline — especially in light of President Barack Obama’s pledge to start pulling out troops in July 2011. Not only are Afghans preparing for the worst, but they are also searching for explanations for how, eight years after the war began, the Taliban seems stronger than ever and the United States appears cowed, talking of exit strategies and reconciliation. Most Afghans cannot imagine how a group of bearded mountain men with Kalashnikovs and roadside bombs can really pose such a threat to the all-powerful U.S. military and its technology. (I was told over and over of the U.S. military’s ability to strike a target “within three inches.”)

The future of Afghanistan, then, is not about military strategy, about which side the Afghans like more, or about democracy and human rights. It is about who the Afghans think will be strongest in five or ten years; it is about picking the winning side, about survival. If Afghans believe that the Taliban-led insurgents plan to be around longer than the more powerful West and are stronger than Afghan government security forces, Afghans will tilt toward the Taliban. And if Taliban leaders and their underlings begin to sense this, they will have no incentive to negotiate or reconcile with the Afghan government or the U.S.-led coalition.

On my recent trip, I met with five senior NATO military officials who told me that the situation in Afghanistan was the worst it had ever been. It was, as they described it, a perfect storm of bad news: a flawed presidential election, a deeply corrupt government, an attack on a UN guesthouse that caused the United Nations to retrench, and a perceived reluctance in Washington about a long-term commitment in Afghanistan.

In past years, I had typically been told that the insurgents had a core group of 3,000 members who could recruit a total of perhaps 10,000 anti-government fighters. But on this trip, I was told that there were as many as 25,000 hard-core fighters — with as many as 500,000 people waiting to side with whomever seemed to gain the upper hand. As one senior military official told me, “There are a lot more insurgents than we thought.”

The Taliban is not a monolithic group. Rather, it is a shorthand term that often includes various entities with similar agendas. But the Taliban leadership council, or shura, in Quetta — the movement most closely linked with Mullah Muhammad Omar and the former regime in Kabul — is considered to be the group most interested in actually running Afghanistan, as opposed to merely fighting international troops and creating terror. It is no accident that the most serious challenge posed by any insurgent group to the Afghan government — and therefore to the U.S. troop surge — is based in Quetta, a provincial capital in Pakistan. Western military officials said that although the Pakistani military has increased efforts against militants inside its own borders, it must do much more. “I think the Pakistanis are scared to death,” one senior official told me. They are especially worried, he said, by “their inability to do anything about it.”

The senior official also told me that Omar, the Quetta shura’s reclusive leader, had installed five regional military commanders this year — just as the U.S.-led coalition has in Afghanistan. Several of these were dispatched by the Taliban shura to areas they were not from, showing a growing sophistication in Taliban military strategy that relies on the best military minds and not just homegrown allegiances.

Meanwhile, the Quetta shura has developed shadow governments in 33 of Afghanistan’s 34 provinces, as well as “redress” committees, where Afghans can complain about Taliban behavior, such as roadside bombs that kill Afghans. Western military officials and diplomats fear that the Taliban insurgents are doing much more than the Afghan government to establish good governance and accountability. The Taliban has also set up committees for aid groups. This means that, in theory at least, if aid groups agree to Taliban conditions and aid gets delivered to remote areas, the Taliban could claim the credit and not the government.

In the remote provinces, the Taliban’s efforts have had the effect of reinforcing the image of an absent Afghan central government (or of a government that is present but corrupt). In its place, the Taliban have been able to shore up their footprint across the countryside and display measures of accountability.

This is not just happening in the south, the Taliban’s traditional stronghold, but also in the north, in formerly Taliban-free provinces such as Kunduz. Coalition military officials said that Mullah Abdul Ghani Baradar, Omar’s deputy who is responsible for day-to-day Taliban operations, has started polling Afghans in the north about their satisfaction with the Karzai government and such government services as education.

President Hamid Karzai’s plan to solve the morass focuses on reintegrating the Taliban within the Afghan government. In his inauguration speech, he put national reconciliation at the top of the country’s attempts to establish peace and said he would soon call aloya jirga, or meeting of tribal elders, to discuss it. “We welcome and will provide necessary help to all disenchanted compatriots who are willing to return to their homes, live peacefully, and accept the constitution,” he said. “We invite dissatisfied compatriots who are not directly linked to international terrorism to return to their homeland.”

This effort is backed by the United States and the United Kingdom, along with other allies. Taliban leaders, however, have said that they will only negotiate if international forces agree on an exit plan and if the Taliban are able to set up an Islamic state. But considering the election and Karzai’s eroding legitimacy, the Taliban seem to have a much stronger negotiating position than Karzai does. They also appear to be closer to al Qaeda than ever before. UN officials told me that the bombing of the UN guesthouse in Kabul was coordinated by the Taliban’s Quetta shura, al Qaeda, and the Haqqani network, a militant group based in Pakistan’s tribal areas.

The United States hopes to be able to win over mid-level Taliban commanders with offers of jobs, protection, and even money. But this will be tough. Afghans remember examples of retribution, such as when Mullah Abdul Salaam Alizai, a former Taliban commander in Helmand, rejoined the government in December 2007, only to see at least 23 of his family members and supporters killed in attacks. Most of the senior former Taliban members who have renounced the group are practically under house arrest in Kabul for their own safety.

Unless Taliban members and their families can be protected in the hinterlands, where the government holds little sway, it is unlikely that many will switch allegiances. Providing such protection in population areas is one of the goals of the increased U.S. troop presence, most especially in Helmand, though extending this sort of shield across the whole country may take far more than 30,000 additional soldiers.

Money is another complicating factor. Past attempts to pay off Afghans to stop growing poppies or to hand over their weapons have been resounding disasters. The poppy program actually increased the poppy supply, because more farmers began growing poppies so they could then get money to stop; while many Afghans handed over ancient weapons expecting compensation. Recently, a man claiming to be an Uzbek member of the Taliban showed up at the U.S. embassy in Kabul saying he could guarantee the reconciliation of 300 Uzbek Taliban members — that is, if he were paid enough money.

In the end, Afghans say, reconciliation will only stand a chance if the West sticks around. Obama’s talk of starting to pull out as soon as the summer of 2011 will likely fuel suspicion that the United States already has one foot out the door.

“We need to recognize how long it’s going to take,” said Ashraf Ghani, a candidate in the last Afghan presidential election and the co-author of Fixing Failed States: A Framework for Rebuilding a Fractured World. “How long?” I asked. Seven years, Ghani said, and no matter what, he added, some Taliban members “may never change.”

This is a number that is sure to frighten many policymakers in Washington, including the president himself. No matter how long U.S. forces stay to battle the Taliban, the ordeal is sure to tire many Afghans, most of whom have never lived a year without fighting.

Copyright © 2002-2009 by the Council on Foreign Relations, Inc.
All rights reserved.

November 23, 2009

The Future That Was

China’s economic model is reminiscent of 17^thcentury mercantilist policies. Thomas Mun, a Director of the East India Company, in England’s Treasure by Foreign Trade (1664), wrote that the purpose of trade was to export more than you imported. At the same time, a country should amass foreign ‘Treasure’ that would be the basis of acquiring foreign colonies to allow control of essential natural resources. The strategy required reducing domestic consumption and imports and export of goods manufactured with imported foreign raw materials. China’s strategy coincides almost entirely with Mun’s views.

China’s mercantilist strategies have important implications for other developing countries. Chinese investment in and trade with Latin America and Africa is concentrated on securing access to resources forcing these nations to specialise in commodities. This reversion to a 19^th century trend may not be compatible with Latin American and African long term development and stability.

The Chinese economic model may be unsustainable. It relies on global trade and investment (much of it export related), which together contribute a high proportion of China’s GDP. This trade entails importing foreign components that are then reassembled and then exported. Domestic consumption has been kept low. Treasure has been built up in the form of domestic savings and trade surpluses.

Recently, China announced that its $2 trillion treasure would be used to make foreign acquisitions to secure exclusive access to raw material. The problem is that China’s treasure is already invested in assets of dubious value and limited liquidity to finance global consumption.

Chinese Premier Wen Jiabao warned that the Chinese growth was becoming increasingly “unstable, unbalanced, uncoordinated and ultimately unsustainable“. That was two years ago! Currently, China may be aggravating the problems by massive liquidity-driven stimulus to perpetuate a failed strategy. Speaking at the meeting of the World Economic Forum in Dalian on 10 September 2009, the Chinese Premier Wen Jiabao repeated his message from two years ago without signalling any change in direction: “China’s economic rebound is unstable, unbalanced and not yet solid. We cannot and will not change the direction of our policies when the conditions aren’t appropriate.“

There is broad agreement that a key component of the GFC was the problem of global capital imbalances. A central feature was debt-funded consumption by the U.S. that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit. Japan, China, Germany and the other savers funded the consumption.

Any lasting solution to the GFC requires this imbalance to be dealt with. The glib solution requires the U.S. to save more and consume less and the savers to save less and consume more. The problems in implementing the solution are considerable. Timothy Geithner’s recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury Bonds, reveals the dilemma.

On the one hand, America needs the Chinese to continue and increase their purchase of U.S. Government debt to finance its fiscal stimulus and bailouts. On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings. All this should also occur ideally without any major decline in the value of the dollar or U.S. Treasury bonds or the need for China to liberalise it currency and allow internationalisation of the Renminbi.

A cursory look at the respective economies also highlights the magnitude of the task. Consumption’s contribution to GDP in the U.S. is 71% while in China it is 37%. Given that the GDP of China is around $4-5 trillion versus $15 trillion for the U.S. and average income in China is around 10-15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.

During the last quarter of century, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American and European buyers, lower global growth and declining consumption creates significant challenges for China.

Dealing with the global imbalance has not been a high priority in the various summits global leaders have shuttled to and from.

In March 2009 in advance of schedule G-20 meeting, the Chinese central bank proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund. In an essay posted on the Peoples’ Bank of China’s website, Zhou Xiaochuan, the central bank’s governor, argued that creating a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies“. Mr. Zhou wrote: “The outbreak of the [current] crisis and its slipover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system.”

The US predictably dismissed the proposal. The Wall Street Journal argued that: “For all its faults, the dollar is attractive as a reserve currency because it is the common language of global finance and trade. In other words, its appeal is proportionate to how many other market players use it. For decades, the dollar has been a convenient medium of exchange for everyone from a central bank seeking to buy US Treasury bonds to a business exporting commodities from Latin America to Asia.” The unstated reason was the loss of the ability to finance itself in its own currency would significantly disadvantage the US.

In July 2009, at the G8 Summit in the earthquake damaged town of L’Aquila in Italy, Dai Bingguo, Chinese state councillor, was again openly critical of the dominant role of the U.S. dollar as a global reserve currency: “We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies exchange rates and promote a diversified and rational international reserve currency system,”

Western leaders expressed concerns about even raising the issue fearing that discussion of long-term currency issues could undermine the nascent recovery in markets and economies. Gordon Brown, Britain’s prime minister, spoke on behalf of the West: “We don’t want to give the impression that big change is around the corner and the present arrangements will be destabilised.” The West it seems was heeding Deng Xiaoping’s advice to: “Keep a cool head and maintain a low profile. Never take the lead – but aim to do something big.“

In September 2009, the Americans and Europeans proposed an effort to tackle global economic imbalances at the G20 summit in Pittsburgh. Against a background of rising trade tensions, China’s ambassador to the U.S. Zhou Wenzhong expressed scepticism about the proposals, seeking focus instead on avoiding protectionism.

Still heavily reliant on exports, China was wary of a global push on imbalances that would focus of its large trade surplus (which reached nearly 10 per cent of GDP in 2008). Zhou pointedly blamed the crisis on “the lack of supervision and abuse of the openness of the market, very risky levels of leverage and too much speculation.” He proposed improving global financial supervision, strengthen bank capital and create global early warning systems to identify threats but resisted action to address the imbalance.

Ironically, recent modest improvements in the global economy potentially risked increasing the same imbalances that were one of the factors that caused the current financial crisis. China’s and the world’s economic future requires resolving fundamental global imbalances that lie at the heart of the GFC.

Turning Japanese

China’s problems, to a degree, mirror earlier problems of Japan, its neighbour and competitor for global influence.

Japan’s export driven model successfully generated strong growth of 10% average in the 1960s, 5% in the 1970s and 4% in the 1980s. This growth was driven by a number of factors, including an artificially low exchange Yen rate.

On 22 September 1985, Japan, the U.S., the U. K., Germany and France signed the Plaza Accord agreeing to depreciate the dollar in relation to the Japanese Yen and German Deutsche Mark by intervention in currency markets. The Accord had limited success in reducing the U.S. trade deficit or helping the American economy out of recession.

The Plaza Accord signalled Japan’s emergence as an important participant in the international monetary system and global economy. The effects on the Japanese economy were disastrous.

The stronger Yen triggered a recession in Japan’s export-dependent economy. In an effort to restart the economy, Japan pursued expansionary monetary policies that led to the Japanese asset price bubble that collapsed in 1989. Economic growth fell sharply and Japan entered an extended period of lower growth and recession, generally referred to as ‘The Lost Decade’.

In the 1990s, Japan ran massive budget deficits to finance large public works programs in a largely unsuccessful attempt to stimulate growth to end the economy’s stagnation. Only structural reforms in the late 1990’s and early 2000’s restored modest rates of growth. Japan’s public debt is now approaching 200% of Japan’s GDP.

Significant shifts in economic strategy are now necessary. Chinese President Hu Jintao recently noted: “From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies.”

China can try to continue its existing economic strategy, which looks increasingly difficult. Changing its economic model is also difficult if it means a slower rate of growth. China’s challenge will be to learn from and avoid the problems and fate of Japan.

History and cultural issues compound China’s dilemma. The 1842 Treaty of Nanking entered into at the end of the first Opium War awarded Britain war reparations, eliminated the Chinese Hong monopoly, set Chinese exports and imports at a low rate, provided British access to several Chinese ports and transferred Hong Kong to the English. The humiliation of the Treaty is deeply etched into China’s dealing with the West.

China should have heeded the warning of Kang His, emperor of China, on the British presence at Canton in 1717: “There is cause for apprehension lest in centuries or millennia to come China may be endangered by collision with the nations of the West.”

The trade-off between economic and political liberalisation may also be problematic. As Fang Li, a renowned astro-physicist often called China’s Andrei Sakharov, remarks in dissident author Ma Jian’s novel about China “Beijing Coma”: “Without a democratic political system in place, [China’s] economy will eventually flounder. The people’s wealth will be eaten up by the corrupt institutions of this one party state.”

There is an apocryphal story about a visiting world leader drawing back the current of his hotel room to be stunned by the futuristic skyline of Shanghai’s Pudong Financial District. “How long has this being going on?” He asked. Today, the question might be: “How long can this go on?”

© 2009 Satyajit Das

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

Real world dealing . . . .

BP lobbied Jack Straw before he changed mind over Lockerbie bomber

Sep 4th, 2009 by John Donovan.

Tom Baldwin and Philip Webster

Jack Straw was personally lobbied by BP over Britain’s prisoner transfer agreement with Libya just before he abandoned efforts to exclude the Lockerbie bomber from the deal.

The Times has learnt that the Justice Secretary took two telephone calls from Sir Mark Allen, a former M16 agent, who was by then working for BP as a consultant, on October 15 and November 9, 2007.

Having signed a $900million oil exploration deal with Libya earlier that year, BP feared that its commercial interests could be damaged if Britain delayed the prisoner transfer agreement (PTA) through which the Gaddafi regime hoped to secure the return home of Abdul Baset Ali al-Megrahi.

For six months talks with Libya were deadlocked as Britain — under pressure from the devolved Scottish government — vainly sought to ensure the PTA would not cover al-Megrahi.

On December 19, 2007, Mr Straw wrote to Kenny MacAskill, the Scottish Justice Minister, to say that he had been unable to secure an exclusion for al-Megrahi from the deal.

“The wider negotiations with the Libyans are reaching a critical stage and in view of the overwhelming interests for the United Kingdom I have agreed that in this instance the PTA should be in the standard form and not mention any individual,” he wrote.

Britain has already faced criticism from the Obama Administration for signing the PTA despite a decade-old promise to the United States that anyone convicted of the Lockerbie bombing would serve out the sentence in Britain.

The fresh disclosures last night may yet throw doubt over Gordon Brown’s assertion on Wednesday that there had been “no conspiracy, no cover-up, no double-dealing, no deal on oil, no attempt to to instruct Scottish ministers, no private assurances by me to Colonel Gaddafi”.

An aide to the Justice Secretary confirmed last night that Sir Mark, who had dealt often with Mr Straw when he was Foreign Secretary, “wanted to know what was happening with the PTA and get Jack’s perspective”. He added: “BP wanted to make its case because they were concerned that not making progress might have an effect on their deal with Libya.”

The Times has learnt that Sir Mark, a pivotal figure in negotiations leading to Libya’s abandonment of its weapons of mass destruction in 2003, was alsoinstrumental in securing the BP oil deal. In 2005 he flew to Libya with Lord Browne of Madingley, then the BP chief executive, where he introduced him to Colonel Gaddafi and oil chiefs.

Although in his telephone conversations with Mr Straw, Sir Mark is said to have avoided explicit reference to al-Megrahi’s fate, a government source acknowledged this would have been unnecessary because it was “well known that the Libyans were resisting pressure for an exclusion” — and that was holding up the treaty. It is understood that between the two calls, Justice Department officials had concluded that the negotiating position agreed between the British and Scottish governments was unsustainable.

Mr Straw’s aide said: “Jack has always stated that he took into account the overall impact of the agreement across a whole range of issues — and those included trade. He took this decision in the certain knowledge that the Scottish government always had a veto on releasing al-Megrahi.”

As recently as last week, BP flatly denied it made any representations to the Government over the impact of the prisoner transfer deal on the oil contract  with Libya. The company rejected suggestions that Libya was exerting pressure on its operations over al-Megrahi’s release.

Last night, however, a spokesman said: “BP did bring to the attention of the Government in late 2007 our concerns about the slow progress in concluding a PTA with Libya. Like many others we were aware that delay might have negative consequences for UK commercial interests including ratification of BP’s exploration agreement.”

He added: “We did not press for any particular kind of PTA, we were just hoping for an end to the delays concluding it.”

Libya has a long tradition of demanding political concessions in exchange for business deals. A representative of the Russian oil company OAO Lukoil was jailed briefly when commercial negotiations with Libya reached a difficult point in 2007 before being released in July 2008.

When police arrested Colonel Gaddafi’s son, Hannibal, and his pregnant wife in Geneva on assault charges, reprisals led to Swiss businessmen in Tripoli being imprisoned, flights into the country halted, oil exports cut and more than $5 billion withdrawn from Switzerland’s banks.

The BP oil deal was signed when Tony Blair shook hands with Colonel Gaddafi on plans for a PTA in May 2007. Oliver Miles, a former British Ambassador in Tripoli and vicechairman of the Libyan British Business Council, said: “BP was thrown out for political reasons in the 1970s and they only returned when the politics were right.

“During the PTA negotiations, I heard from business people in Libya that the authorities there may have played the BP card again.”

He added: “Certainly, if al-Megrahi had died in prison, the Libyans were saying that all bets are off.”

Nick Day, a former MI5 agent and the chief executive of the business intelligence firm Diligence, which has helped British companies to enter Libya, said: “It was an open secret on the ground there that other oil firms were not encountering the same difficulties that BP had … because the whole issue of al-Megrahi was unresolved.

“Any government has the overwhelming priority of ensuring the economic wellbeing of the country, protecting national security and furthering bilateral relations. This is clearly what Britain was doing in this case — and there is nothing wrong with it. The problem is that governments do not always feel able to tell people the whole truth.”

Despite Rhetoric, Obama Still Following Cheney’s Lead in Dictatorial Justice

It seems like the former vice-president is the one piggybacking on the new president’s detainee policy spotlight, but a top foreign-policy analyst argues that, when it comes to tribunals, it’s the other way around: the Obama administration is maintaining the practice of inventing justice as America sees fit.

By Thomas P.M. Barnett

Soren McCarty/WireImage.com (Obama); Manny Ceneta/Getty (Cheney)

This morning, even as the man whose misguided sense of justice started this whole “mess” was preparing to beat him back down on the issue, President Obama sought to distance himself more than ever before from the last administration on detainees — and what the hell to do with them. “Decisions over the last eight years developed an ad hoc legal approach for fighting terrorism that was neither effective nor sustainable,” Obama said in a major speech moments ago, “a framework that failed to trust in our institutions, and that failed to use our values as a compass.”

And despite more answers than ever before on the most controversial issue of the day, the president might as well have been talking to himself when he said “there are no neat or easy answers here.” In fact, when it comes to the thorniest nuance of the detainee issue — not their release, but their trial in Bush administration-invented military commissions — he didn’t offer many good answers at all.

President Obama’s decision to stick with a modified version of these tribunals — “an appropriate venue for trying detainees,” as he called them today — seriously undermines his campaign pledge to turn the page on Bush-Cheney’s deeply flawed approach to terrorism. No matter how many times he enumerates the “swift changes” by his administration to ditch its predecessor’s out-of-thin-air concepts — “war on terror,” “enhanced interrogation methods,” “unlawful enemy combatants” — Obama continues to promote Bush-Cheney’s isolating notion that detainees should be tried in a special, U.S.-executive-branch-controlled system ofalternative justice that lies outside of two proven pillars of traditional justice: the military’s ever-effective courts martial and our civilian court system, which is held in place by the same safeguards of the Constitution that Obama invoked so many times this morning.

Beyond the rhetoric, then, Obama has told the world that America’s definitions of terror remain its own. He says it’s not a reversal? It is. The president has reminded the world of a Cheney-ism: We know terrorism when we see it, and when we see it, we’ll let you know.

Clearly, this approach undercuts our international moral authority on the subject of terror, making our efforts seem less an attempt to bolster international rules and more a continued rationalization for going anywhere and doing whatever to whomever we choose to define as enemies of our state. By continuing to justify an exceptional system, Obama chooses to perpetuate nothing less than an international version of the same sort of dictatorial practices that America routinely condemns “bad” regimes for using within their own borders.

Hedging on Absolutism, More Power in the Opinions of Men

Obama made a point of noting in his speech today that the Bush-Cheney calculation of Guantanamo-plus-military-tribunals-equals-safety has yielded only three convictions in seven years. If that’s his rationale for closing the detention center, then why give the tribunals a pass at all? Here’s a hint from Cheney, who followed Obama’s speech with one of his own: “I think the president will find, upon reflection, that to bring the worst of the worst terrorists inside the United States would be cause for great danger and regret for years to come.”

Obama’s smart enough to foresee the Willie Horton-like ads (“designed to frighten the American people,” as he noted today) that the Republicans will broadcast en masse in the run-up to next year’s mid-term elections. No wonder Congressional Democrats voted to deny the President the funds he needs to close Gitmo down by next January.

So the president’s invocation of “decisions based on fear rather than foresight” may have been aimed as much at his own party as at the man following his speech, but the political wrangling, the Guantanamo funding votes, and even Obama’s promises of more procedural safeguards for defendants at his commissions all miss the larger point: America continues to ignore the utility of building up case law with regard to terrorism — either within our own military/civilian systems or across the international system as a whole, where the International Criminal Court remains a wholly untested option.

Worst of all, Obama seems to be letting the tail wag the dog on this one: In order to keep his more prominent campaign pledge of shutting the doors at Guantanamo, his administration is bowing to the immediate challenge of figuring out how to process this current batch of terrorism suspects in as politically expedient a manner as possible. And to the glee of some Republicans, that sense of urgency has led Obama to essentially bless Bush-Cheney’s past use of special military commissions by correcting it only on the margins. “These reforms,” Obama said today, “will make our commissions a more credible and effective means of administering justice.”

What reforms, you ask? And to what end? Less use of hearsay (Obama now wants prosecutors to bear the burden of proving its reliability), more defendant rights to pick their own lawyers, and more protection for defendants if they choose not to testify on their own behalf. These are slim improvements to a system that Candidate Obama once described as “an enormous failure.” These are indications that President Obama feels the pang of reality — that he must retain this extraordinary option for cases he fears won’t end in convictions in standard military or civilian court settings.

This “modified” approach smells much like Obama’s nuanced take on the CIA’s controversial rendition program by which Bush-Cheney routinely shuttled terror suspects around the world to both regimes known to engage in torture and the CIA’s own infamous “black sites” where agency employees or contractors did much the same. Obama has closed down the CIA sites and banned the torture techniques but has nonetheless indicated that his administration will continue the rendition program. It just promises not to send suspects to places where bad things will happen to them.

What constitutes “bad”? Ah, there again the public is asked to trust Obama-Biden in ways not dissimilar to the trust once abused by Bush-Cheney: instead of trusting the rule of law, we are asked to trust the opinions of men.

I don’t know about you, but that’s not my definition of a republic.

Dispatching of Tribunals, More Opportunity for the International Criminal Court

Here’s how I would modify Obama’s modifications:

First, get rid of the military commissions altogether. Any court that doesn’t build up case law — either at home or on an international scale — is a judicial sinkhole not worth digging.

Second, divide up prosecutions as follows:

1. If suspects commit or plot terrorism directly against the United States (and last night’s arrests reminded us this is still happening actively), they should be tried in U.S. criminal courts — no matter where they’re snatched up. Existing federal laws provide sufficient protection regarding the preservation of classified intelligence-gathering techniques.

2. If suspects do the same inside countries where America’s military is currently conducting operations, they should be tried in U.S. courts martial. Terrorism inside recognized war zones (always a subjective definition) should be handled on the spot. The United States military has used courts martial successfully in virtually every major intervention it has conducted in the post-Cold War era, and its Uniform Code of Military Justice’s protection of due process is admired around the world.

3. In situations when neither of those two conditions are met, and local judicial systems aren’t up to the task (because we’re talking a failed state or a rogue regime that either allows such terrorism or commits it itself), the International Criminal Court (ICC) should be encouraged to step in on the basis that such terrorism constitutes “crimes against humanity.” Most international legal scholars accept this rationale — straight out of the court’s founding treaty — as a legitimate entry point for the ICC, so long as further, clarifying amendments are added to the 2002 Rome Statute. The ICC was set up for exactly this purpose: extend the global community’s legal norms into those frontier-like situations where local governments, such as they are, don’t provide fair trial. Where functioning states exist and such crimes are suitably prosecuted, the ICC — by definition — has no purview. It is designed to fill in the judicial “blanks” on a global basis, which is why virtually all of its cases to date have focused on Africa — ground zero for the world’s failed states. Ultimately, I think we should funnel as many terrorism cases as possible to the ICC, encouraging fellow great powers to do the same, because the more the United States can do that, the faster we collectively build up international case law on transnational terrorism.

Having said that, I don’t harbor any illusions about America — that long-serving military Leviathan of Planet Earth — wanting to prioritize the ICC in the short run. So long as globalization continues to advance around the planet, it will generate localized friction (i.e., attempts to preserve collective identity in the face of globalization’s “dangerous” individual freedoms) that routinely manifests itself as terror-based resistance. And so long as America plays globalization’s bodyguard, we will remain the most universally recognized target of such groups. Those are just the cold, hard facts.

Nonetheless, America needs to recognize that there is a half-life attached to the flawed ideological equation that states the following: Globalization = Westernization = Americanization. The future dictates that our days of serving as the No. 1 target of anti-globalization forces around the planet eventually come to an end. With the rise of globalizing agents such as China and India and Brazil, we’ll inevitably see these states share some of that body-guarding burden. And when they do, I guarantee you that America will prefer those states submit to an international legal code of our patient shaping than having them add their own, self-serving definitions of “universal” justice.

History’s clock is ticking, whether President Obama hears it or not.

Esquire contributing editor Thomas P.M. Barnett is the author of Great Powers: America and the World After Bush.

May 14, 2009, 12:58 PM

Seven Reasons Why Obama’s Nuke-Free Utopia Won’t Work

By Thomas P.M. Barnett