State Capitalism Comes of Age

EDITOR'S NOTE: By promoting foreign investment, free trade and open markets, the United States will ensure that the free market continues to be the most durable substitute to state capitalism, says Ian Bremmer, president of Eurasia Group. For his full essay, please visit the Foreign Affairs magazine's Web site. A few excerpts:

Across the United States, Europe, and much of the rest of the developed world, the recent wave of state interventionism is meant to lessen the pain of the current global recession and restore ailing economies to health. For the most part, the governments of developed countries do not intend to manage these economies indefinitely. However, an opposing intention lies behind similar interventions in the developing world: there the state's heavy hand in the economy is signaling a strategic rejection of free-market doctrine.

Governments, not private shareholders, already own the world's largest oil companies and control three-quarters of the world's energy reserves. Other companies owned by or aligned with the state enjoy growing market power in major economic sectors in the world's fastest-growing economies. "Sovereign wealth funds," a recently coined term for state-owned investment portfolios, account for one-eighth of global investment, and that figure is rising. These trends are reshaping international politics and the global economy by transferring increasingly large levers of economic power and influence to the central authority of the state. They are fueling the large and complex phenomenon of state capitalism.

Not quite 20 years ago, the situation looked a lot different. After the Soviet Union buckled under the weight of its many internal contradictions, the new Kremlin leadership moved quickly to embrace the Western economic model. The young governments of the former Soviet republics and satellites championed the West's political values and began joining its alliances. Meanwhile, in China, liberal market reforms that had been launched a decade before began to breathe new life into the Chinese Communist Party. Emerging-market powers, such as Brazil, India, Indonesia, South Africa, and Turkey, began deregulating their dormant economies and empowering domestic free enterprise. Across western Europe, waves of privatization washed away state management of many companies and sectors. Trade volumes swelled. The globalization of consumer choice and supply chains, of capital flows and foreign direct investment, of technology and innovation strengthened these trends still further.

But the free-market tide has now receded. In its place has come state capitalism, a system in which the state functions as the leading economic actor and uses markets primarily for political gain. This trend has stoked a new global competition, not between rival political ideologies but between competing economic models. And with the injection of politics into economic decision-making, an entirely different set of winners and losers is emerging.

Principal actors

State capitalism has four primary actors: national oil corporations, state-owned enterprises, privately owned national champions, and sovereign wealth funds (SWFs).

A more recent trend has complicated this phenomenon. In some developing countries, large companies that remain in private hands rely on government patronage in the form of credit, contracts, and subsidies. These privately owned but government-favored national champions get breaks from the government, which sees them as a means of competing with purely commercial foreign rivals, and they are thus able to carve out a dominant role in the domestic economy and in export markets. In turn, these companies use their clout with their governments to gobble up smaller domestic rivals, reinforcing the companies' strength as pillars of state capitalism.

The task of financing these companies has fallen in part to SWFs, and this has greatly expanded those funds' size and significance. Governments know they cannot finance their national champions simply by printing more money; inflation would eventually erode the value of their assets. And spending directly from state budgets could leave a shortfall in the future if economic conditions deteriorated. Thus, SWFs have taken on a greater role. They act as repositories for excess foreign currency earned from the export of commodities or manufactured goods. But SWFs are more than just bank accounts. They are state-owned investment funds with mixed portfolios of foreign currencies, government bonds, real estate, precious metals, and direct stakes in-and sometimes majority ownership of-a host of domestic and foreign firms. Like all investment funds, SWFs look to maximize returns. But for state capitalists, these returns can be political as well as economic.

Although SWFs have gained prominence in recent years, they themselves are nothing new. The Kuwait Investment Authority, now the world's fourth-largest swf, was founded in 1953. But the term "sovereign wealth fund" was first coined in 2005, reflecting a recognition of these funds' growing significance.

Close ties

One essential feature of state capitalism is the existence of close ties binding together those who govern a country and those who run its enterprises.

First, commercial decisions are often left to political bureaucrats, who have little experience in efficiently managing commercial operations. Often, their decisions make markets less competitive and, therefore, less productive. But because these enterprises have powerful political patrons and the competitive advantages that come with state subsidies, they pose a great and growing threat to their private-sector rivals.

Second, the motivations behind investment decisions may be political rather than economic. The leadership of the Chinese Communist Party, for example, knows that generating economic prosperity is essential to maintaining political power.

If business and politics are closely linked, then the domestic instabilities that threaten ruling elites-and, more specifically, their definition of the national interest and their foreign policy goals-begin to take on greater importance for businesses. For outsiders, better understanding these political motivations has become a coping strategy. Many private companies doing business in emerging markets have learned the value of investing more time in closer relations with both the government leaders who award major contracts and the bureaucrats who oversee the legal and regulatory frameworks for their implementation. For multinationals, this expense of time and money might seem like a luxury at a time of global recession, but to protect their overseas investments and market share, they cannot afford to do otherwise.

Enter the state

State capitalism began to take shape during the 1973 oil crisis, when the members of the Organization of the Petroleum Exporting Countries (OPEC) agreed to cut oil production in response to the United States' support of Israel in the Yom Kippur War. Almost overnight, the world's most important commodity became a geopolitical weapon, giving the governments of oil-producing countries unprecedented international clout. As a political tool, OPEC's production cuts served as embargoes against specific countries- in particular, the United States and the Netherlands. As an economic phenomenon, the oil crisis reversed the previous flow of capital, in which the oil-consuming states bought ever-larger volumes of cheap oil and in turn sold goods to the oil-producing countries at inflationary prices.

A second wave of state capitalism began during the 1980s, driven by the rise of developing countries controlled by governments with state-centric values and traditions. At the same time, the collapse of governments that relied on centrally planned economies for growth caused a surge in global demand for entrepreneurial opportunity and liberalized trade. That trend, in turn, sparked rapid growth and industrialization in several developing countries during the 1990s. Brazil, China, India, Mexico, Russia, and Turkey, along with countries in Southeast Asia and many others, moved at different speeds along the path from developing to developed.

A third wave of state capitalism was marked by the rise of SWFs, which by 2005 had begun to challenge Western dominance of global capital flows. These capital reserves were generated by the huge increase in exports from emerging-market countries. Most SWFs continue to be run by government officials, who treat the details of their reserve levels, investments, and management of state assets as something close to a state secret. As a result, it is not clear to what extent these funds' investment and acquisition decisions are influenced by political considerations.

A fourth wave of state capitalism has now arrived, hastened by the recent global economic slowdown. But this time, the governments of the world's wealthiest countries, and not just those of emerging-market countries, are the ones intervening in their economies. In the United States, lawmakers have intervened in the economy despite the public's historic mistrust of government and its faith in private enterprise. Australia, Japan, and other free-market heavyweights have followed suit. In Europe, a history of statism and social democracy makes nationalization and bailouts more politically palatable.

The road ahead

A growing number of Americans have come to believe that globalization moves their jobs to other countries, depresses their wages, and exposes U.S. consumers to shoddy foreign products. By 2012, there is likely to be at least one major U.S. presidential candidate who stands on a neo-isolationist, "Buy American" platform. If U.S. lawmakers are to avoid this protectionist trap, they would do well to relearn the lessons of the 1930 Smoot-Hawley Tariff Act, which raised tariffs on 20,000 imported goods to record levels, prompted retaliation in kind, and thus deepened and lengthened the Great Depression.

The global financial crisis has created an illusion of international unity based on the mistaken fear that everyone is sinking in the same boat. A year ago, the talk in policy circles was of "decoupling," the process by which emerging economies develop a domestic base for growth broad enough to free them from dependence on consumer demand in the United States and Europe. Predictions of decoupling have proved premature. Economic problems originating largely in the United States have forced a hard landing in dozens of developing countries by crushing demand for their exports.

The United States can no longer count on strategic partners to buy its debt, as it did on Japan and West Germany in the 1980s. It must now rely on strategic rivals, particularly China, which does not believe that the United States can indefinitely retain its role as the global economic anchor. Hoarding dollar reserves has helped Beijing keep the value of the Chinese currency low, boosting China's exports and generating record trade surpluses. But China's priority now lies in building its domestic market to create a new model of economic growth that depends less on exports to the United States and Europe and more on demand from Chinese consumers. When and if China succeeds, "decoupling" will become a more meaningful term, and China will have less incentive to buy U.S. debt. If fewer countries want U.S. Treasury bills, the interest rate will have to be raised to make them attractive to buyers, and this will mean longer-term U.S. indebtedness. The United States' economic recovery, once it begins, will thus be slower, and the erosion of the dollar's position as the world's reserve currency will accelerate.

The U.S. government might conclude that its power to set and enforce global economic rules is on the wane. It cannot, in any case, have much faith in playing a leadership role in the G-20 (the group of major economies). This forum includes emerging powerhouses, such as China and India, which have been excluded from the G-7 (the group of highly industrialized states), and the natural divergence between their economic interests and those of the developed states will make it difficult to build any consensus on the toughest economic challenges. The problem is amplified by the tendency of politicians, in both the developed and the developing worlds, to design stimulus packages with their constituencies, not the need to correct macroeconomic imbalances, in mind.

Now is the time for the United States to welcome new infusions of foreign investment, including from SWFs. Some proposed investments already require careful review to ensure that they do not compromise U.S. national security. As long as such a review is genuine, rather than a political effort to discourage foreign investment, it need not dissuade investment proposals. The need to protect their investments will give foreign governments and companies a greater stake in the stability of the U.S. financial system. Mutually assured financial destruction will ensure that state capitalist countries understand that it is also in their interest for the United States to remain economically successful.

Whether free-market capitalism will remain a viable long-term alternative will depend in large measure on what U.S. policymakers do next. Success will depend not just on making good economic policy calls but also on continuing to make the overall U.S. brand compelling. Washington must preserve the United States' huge comparative advantages in hard power-an area in which the United States still outspends China ten to one and outspends all the other states of the world put together-and soft power, which the Obama administration has, so far, improved by enhancing the United States' image worldwide.

State capitalism will not disappear anytime soon. Throwing up walls meant to deny access to U.S. markets will not change that. Instead, profiting from commercial relations with state capitalist countries is in the United States' near-term economic interests. For the sake of the United States' and the world economy's long-term prospects, defending the free market remains an indispensable policy. And there is no substitute for leading by example in promoting free trade, foreign investment, transparency, and open markets, in order to ensure that the free market remains the most powerful and durable alternative to state capitalism.

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