FUTURECASTS JOURNAL

The U.S./China Power Relationship

(with reviews of "The Future of Power," by Joseph S. Nye, Jr., and
"Red Capitalism" by Carl E. Walter and Fraser J. T. Howie)

April, 2011
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Prospects for U.S. Power and Influence

Relative power:

 

 

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  The power and influence of the larger developing nations like China and India will undoubtedly continue to expand to a considerable extent in both absolute and relative terms for some time to come. Rising from the low economic bases of their previous dysfunctional socialist economic systems, they will certainly gain in all aspects of power and influence relative to established powers like the United States.
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For the foreseeable future, the only comparison that really counts is that between the U.S. and China.

 

The U.S. does not worry about soft power and hard power advances in Brazil or India although both are outside the network of formal U.S. alliances. Russia, currently propped up by price inflation for its energy exports, is presently essentially a declining power with growing internal problems.

  However, the real issue is whether and for how long U.S. power and influence can remain predominant in international affairs, and what the future will be like if that status cannot be maintained. For the foreseeable future, the only comparison that really counts is that between the U.S. and China.
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  Nations like India and Brazil, although developing with commendable rapidity, still labor under massive economic limitations that will constrain their future prospects and in any event are unlikely to find themselves in serious conflict with U.S. foreign policy. The U.S. does not worry about soft power and hard power advances in Brazil or India although both are outside the network of formal U.S. alliances. Russia, currently propped up by price inflation for its energy exports, is presently essentially a declining power with growing internal problems.
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  In "The Future of Power," Joseph S. Nye, Jr., again addresses the multifaceted nature of power and influence in foreign affairs and the prospects for U.S. power and influence in the modern world. In defining power relationships, he takes an outcomes approach that is based on broader factors than mere resources available.
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  In "Red Capitalism: The Fragile Foundation of China's Extraordinary Rise," Carl E. Walter and Fraser J. T. Howie
shed considerable light on the limiting factors in China's industrial policy and financial system that must be considered when evaluating the extent to which its power and influence can rise. See, "Prospects for China's Power and Influence," below.
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  Nye's book refines and further develops his earlier work and is, like them, essential reading for the policy analyst. For a more thorough review of his basic concepts see, Nye, "The Paradox of American Power," and Nye, "Soft Power: The Means to Success in World Politics." This current work has an increased emphasis on the current power relationship between the U.S. and China.
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Smart power:

 

 

 

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  "[We] must pay more attention to contexts and strategies," Nye emphasizes.

  "Power conversion strategies turn out to be a critical variable that does not receive enough attention. Strategies relate means to ends, and those that combine hard and soft power resources successfully in different contexts are the key to smart power."

In complex modern interdependent relationships, soft power approaches are the primary tools of policy.

 

Power must be rendered "smart" by effective strategy and tactics and a thorough understanding of the circumstances.

  Preference formation and agenda setting is the basis for most foreign policy among post-industrial democracies, Nye points out. Force is a last and diminishing resort, currently pertinent only among second world industrializing and third world pre-industrial undeveloped nations. In complex modern interdependent relationships, soft power approaches are the primary tools of policy.
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  For analytical purposes, Nye divides power relationships among various categories, but emphasizes that the distinctions are necessarily fuzzy at the borders and policy generally involves a mix of resources across categories. He goes at considerable length distinguishing the categories along pragmatic lines that he considers most useful for the formation and evaluation of policy.

  "Fully defined, soft power is the ability to affect others through the co-optive means of framing the agenda, persuading and eliciting positive attraction in order to obtain preferred outcomes."

  Military resources, for example, can be a significant soft power instrument when used for disaster relief, and soft power attractiveness that turns indigenous people into active allies can play an important - even determinative - hard power role. One of FUTURECASTS favorite examples is when indigenous islanders decided to provide needed support for allied coast watchers during the WW-II battle of Guadalcanal.

  Having power resources is not the same thing as the ability to use them effectively. Strategy and tactics and acquiring an understanding of the terrain are always vital. Power must be rendered "smart," Nye emphasizes, by effective strategy and tactics and a thorough understanding of the circumstances.

  Beware generals who do not bother to examine the actual terrain of the battlefield, and government authorities who denigrate the importance of the cultural environment of the peoples in the conflict space.

Hard power:

 

 

 

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  The use of force has become increasingly complex and costly and often of limited effectiveness because of the thickening web of interconnections among peoples and nations.

  "Even though force remains a critical instrument in international politics, it is not the only instrument. The use of economic interdependence, communication, international institutions, and transnational actors sometimes plays a larger role than force."

Although visibly declining somewhat in relative importance, military capabilities still remain absolutely essential in creating sufficient security for the effectiveness of other forms of power.

  Modern warfare is now a hybrid activity involving soft as well as hard power.

  "In hybrid wars, conventional and irregular forces, combatants and civilians, physical destruction and information warfare become thoroughly intertwined. Moreover, with cameras in every cell phone and Photoshop on every computer, the information contest is ever present."

  These factors limit the effectiveness of modern warfare, but more so for democratic states than for the array of despotisms that still rule by terror rather than by consent. However, Nye points out, even despots ignore economic prosperity and other soft power attractions at their peril. (China is well aware of this, but such awareness has only recently arrived for several despots in North Africa and the Middle East.)
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  Nye provides considerable coverage of the complexities of modern military strategy and tactics, the nature of modern conflict spaces, and the need to include soft power considerations in all aspects of the application of military force. Hearts and minds can be more important targets than tanks and ships or industrial plants, and becomes increasingly important when military capabilities support diplomacy, alliances and less formal relationships. (During WW-II, Germany had to employ 60 divisions in occupation duties.)

  "The important point is that the soft power that arises from qualities of benignity, competence, legitimacy, and trust can add leverage to the hard power of military force. Strategies that combine the two successfully represent smart military power."

  Nevertheless, although visibly declining somewhat in relative importance, military capabilities still remain absolutely essential in creating sufficient security for the effectiveness of other forms of power. (Terrorists gain significant tactical and even strategic advantage if they can render conflict spaces sufficiently insecure to prevent normal commercial activities and development.)
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  Nye provides a similar analysis for the development, maintenance and use of economic power. Governments draw material and financial resources from their economies by various means and with varying consequences. Economic systems vary in their sensitivity and vulnerability to market and policy disruptions.

  "A robust and growing economy provides the basis for all instruments of power. In addition, economic tools like sanctions and aid will be crucial in this century because they are often the most efficient instruments in terms of relative costs. But it is a mistake to argue that the twenty-first century will be the age of geoeconomics."

  A strong currency and healthy budget and international payments accounts provide considerable protection against financial and economic shocks - something those advocating monetary inflation and budget deficits as a means of economic manipulation generally ignore. The economic flexibility derived from monetary and financial strength is a primary factor in responding to changing conditions and financial shocks, lends credibility to a nation's diplomatic initiatives and endurance to its military endeavors.

  Nye emphasizes that interdependence on economic relationships is seldom perfectly balanced. This provides one side with power over another. Evaluating such relationships can be difficult. Nye compares the 1980s relationship between the U.S. and Japan with the current relationship between the U.S. and China as of 2009.

  "China has amassed $2.5 trillion of foreign exchange reserves, much of it held in U.S. Treasury securities. Some observers have described this as a great shift in the global balance of power because China could bring the United States to its knees by threatening to sell dollars. But in doing so, China would not only reduce the value of its reserves as the price of the dollar fell, but it also would jeopardize American willingness to continue to import cheap Chinese goods, which would mean job loss and instability in China. If it dumped its dollars, China would bring the U.S. to its knees, but might also bring itself to its ankles."

  Who would have ever thought that the U.S. could be reduced to employing the diplomacy of vapors? The value of China's dollar reserves are going to significantly decline in any event as the Federal Reserve continues its massive expansion of the U.S. money supply.
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   Nations in chronic and substantial international payments deficit ALWAYS decline while a payments surplus can provide an important measure of strength. During the credit crunch, China was able to employ its reserves not only to support domestic stimulus but also for dollar diplomacy loans abroad to such nations as Venezuela.

  Although clearly not the only factors, Nye recognizes that China's influence is growing in many ways in line with its growing economic and financial strength. China gains stability by restricting the convertibility of its currency.

  However, an undervalued yuan  - and other mercantilist measures - create distortions in China's economy similar to and to a far greater extent than the distortions that afflict Japan's economy. Nye recognizes that the role of the dollar as the world's primary reserve currency is a tremendous source of strength for the U.S. that China cannot match under its current monetary policies and politically controlled financial system. See, "Prospects for China's Power and Influence," below.

Military protection, advanced capital markets, property rights and historic credit worthiness currently are sufficient to prop up a declining dollar.

  The reasons why the dollar retains its reserve currency status are summarized by Nye. Military protection, advanced capital markets, property rights and historic credit worthiness currently are sufficient to prop up a declining dollar.

  Nye grieves over the loss of monetary policy discretion, which is one of the costs imposed by the money markets for maintenance of the dollar's hard currency status. The same complaints used to be made about gold standard constraints. Many supposedly knowledgeable economists actually celebrated the abandonment of the gold exchange standard because of ignorance of the extent that gold had shielded the U.S. from even harsher money market constraints.
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  Of course, the worst of the 1970s inflationary morass came after abandoning gold exchange standard disciplines. Recovery from the 1970s Keynesian inflationary morass required acceptance of high real interest rates and the monetary austerity imposed by Paul Volcker. Two decades of recovery, stability and prosperity were the reward for acceptance of realistic market constraints on monetary policy quite similar to those needed for prosperity under the gold standard. The U.S. will ultimately destroy the strength it enjoys from the hard currency status of the dollar if its budget and payments deficits are not brought under control, and it will find out that money market constraints are unavoidable and far more harsh for soft currency nations.
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  Monetary manipulation has been notoriously unsuccessful in soft currency nations. It is only the dollar's hard currency status that gives monetary inflation its apparent advantages - and those ALWAYS prove to be temporary at best. See, Bernanke's Bubbles.

China has been especially successful in using economic hard power in getting international support for its positions on Tibet and Taiwan.

 

Nye accurately punctures proposals for "Marshall Plan" efforts in other countries, noting the peculiar circumstances that made the original effort successful.

  The power implications of natural resource exports and imports - especially oil and gas - receive considerable attention by Nye.

  For some reason unexplained by Nye or most other pundits, oil price spikes seem to occur most virulently when Keynesian budgetary deficits and monetary inflation and artificially low interest rates are used by Washington in efforts to manipulate the economy. Could there perhaps be some connection?

  Sanctions involve the most direct hard power use of economic strength. Studies show varying levels of effectiveness. However, despite limited prospects for success, Nye insists that they are often the most effective policy response available. Often, when no real action is palatable, they are politically useful in giving an appearance of action. The U.S. imposed 85 new economic sanctions on foreign nations in the five years between 1996 and 2001. (The realities of economic markets are such that economic sanctions are unlikely to be effective - and indeed will frequently cost more for the nation imposing them than for the target - unless joined in by almost all nations worldwide.)
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  Foreign aid is included in this category as "positive" sanctions. After all, the author points out, aid extended creates a threat of withdrawal. Nye shows several successful uses of  "positive" sanctions by a variety of nations. The same can be said for market access. China has been especially successful, for example, employing access to its huge and growing market to obtain international support for its positions on Tibet and Taiwan.
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  The Marshall Plan after WW-II is the most famous of U.S. assistance efforts. Nye accurately punctures proposals for "Marshall Plan" efforts in other countries, noting the peculiar circumstances that made the original effort successful. The obstacles to success of such efforts are numerous and varied.

  "Like negative sanctions, positive sanctions of payment and assistance have a mixed record as generators of both hard and soft power." (Poor nations are poor because of their own poor governance, something foreign assistance seldom changes.)

Soft power:

 

 

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  Soft power - like all power - can be used for both good and ill purposes. Nye offers some pertinent historic examples where soft power factors proved very effective. The private efforts that recently got China to use its influence with Sudan on behalf of Darfur just prior to the Beijing Olympics are noted as a dramatic recent success for soft power.
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"Soft power may appear less risky than economic or military power, but it is often hard to use, easy to lose, and costly to reestablish." Legitimacy and credibility are always at issue.

 

For "structural milieu goals or value objectives such as promotion of democracy, human rights and freedom," soft power often proves superior to hard power. Smart power strategies must always include soft power factors.

  Neorealists who denigrate soft power because it couldn't be measured properly receive Nye's scorn. Nye call this "the concrete fallacy." 

  The "concrete fallacy" is an intellectual conceit that has widespread pernicious influence in the nonscientific practical arts - the so called "social sciences." It might similarly be applied to mathematical economist efforts to reduce the complexity of whole economic systems sufficiently to fit them into mathematical models. 

  The difficulties of achieving desired outcomes with soft power instruments receive full recognition by Nye. "Soft power may appear less risky than economic or military power, but it is often hard to use, easy to lose, and costly to reestablish." Legitimacy and credibility are always at issue. "Competitive struggles over legitimacy are part of enhancing or depriving actors of soft power, and this is particularly true in the information age of the twenty-first century."
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  Ineffectiveness is no more pertinent as a criticism for soft power than for economic or military power, which also often prove ineffective. For "structural milieu goals or value objectives such as promotion of democracy, human rights and freedom," soft power often proves superior to hard power. Smart power strategies must always include soft power factors.
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China's massive soft power efforts have been undercut in many instances by the crude propaganda agenda of its autocratic party government, by its harsh crackdowns on dissidents domestically and in Tibet and Xianjiang, and by the fear and loathing that its persistent and accelerating military buildup generates in its neighbors.

 

China's words and symbols are simply inconsistent with its realities.

 

Soft power creates "an enabling or disabling environment for government policies" across the entire spectrum of objectives.

  The sources of soft power again receive extensive analysis by the author as in his previous books. He develops this analysis with recent examples like the "Beijing Consensus" that reflects China's growing influence among autocratic third world governments. (See, Halper, "The Beijing Consensus,")
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  For two decades, China has allocated the equivalent of billions of dollars annually into increasingly massive soft power efforts. These efforts have been undercut in many instances, however, by the crude propaganda agenda of its autocratic party government, by its harsh crackdowns on dissidents domestically and in Tibet and Xianjiang, and by the fear and loathing that its persistent and accelerating military buildup generates in its neighbors. It is viewed favorably only in Pakistan and Africa.
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  China's words and symbols are simply inconsistent with its realities. The potency of China's soft power is far less important, Nye emphasizes, than whether it is used for good or ill purposes.
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  The author analyzes at some length the distinguishing characteristics of the "three faces of power" and the subtleties and difficulties of usage. The impacts of modern communications technology are increasingly pertinent. He provides numerous examples of when soft power influences clearly played often critical roles in recent historic events.

  Democratic revolutions in North African Muslim states - whether or not successful - provide dramatic recent examples of Western - and U.S. - soft power at work. The negative aspects of soft power is dramatically demonstrated by the renewal of fear and loathing in their neighbors as Russian and Chinese power and ambitions increase. It is demonstrated by a strengthening of U.S. ties to NATO European states and Asian nations around China's periphery. Renewed fear of Russia is the glue that binds the NATO alliance.
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  Currently, China's growing naval strength and aggressive claims in the South China Sea and East China seas are creating the "containment" environment the prevention of which is a primary Chinese objective. China's neighbors are increasing their naval strength in response to the Chinese buildup and are strengthening their ties to the U.S. The continued ability of the U.S. to project military power in the region is of course vital in providing these nations with hope that they can successfully contest the Chinese claims and the courage to oppose their giant neighbor.
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  For the last century, it is actually the character of its adversaries that has most strengthened U.S. soft power pertinent to its conflicts and generated often vitally important alliances. A prime example that this factor continues during the "War on Terror" was the "awakening"  of Sunni Arab Sheiks in Anbar Province that ignorant critics of the Iraq conflict attribute to mere good fortune. Since WW-I, the U.S. has always relied upon achieving such alliances in its conflicts. The noxious nature of its adversaries has always meant that there would be people within the conflict space ready to join the U.S. effort, and in the nature of things, some of these peoples would be fortuitously in positions where they could be of immense help.
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  Nations that are in fear and loathing of Russian dominance or Chinese foreign policy ambitions, and peoples in fear and loathing of Muslim militants, will always welcome the U.S. as the comparatively benign alternative that permits them to hope they can effectively resist domination. It is of the utmost importance that the U.S. conduct itself in a manner that does not generate such fear and loathing - a point disregarded by the Bush (II) administration.

    As Nye puts it, soft power creates "an enabling or disabling environment for government policies" across the entire spectrum of objectives.
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Nye accurately emphasizes the advantages of the private networked communications that play such vital roles in current popular uprisings. Government propaganda is always suspect.

 

Despotic propaganda programs have not been able to counter the information flows from economic migrants and students studying abroad.

 

"The paradox of using public diplomacy to generate soft power in a global information age is that decentralization and diminished control may be central to the creation of soft power."

  The importance of maintaining public attention and credibility amidst the welter of information flowing in the modern information age is emphasized by Nye. He accurately emphasizes the advantages of the private networked communications that are playing such vital roles in current popular uprisings. Government propaganda is always suspect.
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  China, like other modern despotisms, strives to control information flows and to block or denigrate adverse information. However, despotic propaganda programs have not been able to counter the information flows from economic migrants and students studying abroad.
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  An independent BBC continues to command broad attention and retains credibility all over the world, Nye points out, even after the governments in Britain and the U.S. undermined their credibility with their Iraqi "weapons of mass destruction" fiasco.
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  The Soviet Union maintained a very extensive and effective worldwide propaganda effort generally based on its Communist ideology (which numerous left wing intellectuals lacked the wit to reject), but its soft power objectives were repeatedly undermined by its ham-handed applications of hard power in Hungary, Czechoslovakia and Afghanistan. As Nye points out:

  "Actions speak louder than words, and public diplomacy that appears to be mere window dressing for hard power projection is unlikely to succeed. The treatment of prisoners at Abu Ghraib and Guantanamo in a manner inconsistent with American values led to perceptions of hypocrisy that could not be reversed by broadcasting pictures of Muslims living well in America. In fact, the slick production values of the American satellite television station Al Hurrah did not make it competitive in the Middle East, where it was widely regarded as an instrument of government propaganda."

  China's obsessive efforts to control information flows constitutes a significant weakness. "The paradox of using public diplomacy to generate soft power in a global information age is that decentralization and diminished control may be central to the creation of soft power," Nye points out. Credibility is lost and attention is refused for China's propaganda efforts.
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Cyberdomain conflict:

 

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  The diverse impacts of advances in computing and communications is again well covered by Nye and need not be repeated in this article. "The Information Revolution is leading to a diffusion of power, but larger states still have larger resources," the author again emphasizes.
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  Cyberconflict has both hard power and soft power attributes. Strategy, tactics and characteristics of cyber-war and lesser conflicts have little relationship to those of traditional conflicts. Economic espionage, crime, cyberwar and cyberterrorism pose widely varying problems as do a wide variety of lesser forms of illegitimate internet usage. While governments impose their laws on legitimate cyber domain activity within their boundaries, cyberwar knows no rules. However, Nye points to ongoing efforts among nations to develop them.

  "[While] leaving governments the strongest actors, the cyberdomain is likely to see an increase in the diffusion of power to nonstate actors and network centrality as a key dimension of power in the twenty-first century."

American decline:

 

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  The question of American decline is addressed at length by Nye, specifically in relation to a rapidly rising China. Many analysts compare the current situation to that between Britain and a rapidly rising Germany prior to WW-I.
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  The primary cause of relative decline in U.S. power relationships is the natural power increase from their very low base of emerging nations. Principles of convergence work in favor of newly emerging nations and quickly show up in relative power calculations. It is the extent and prospects for these power relationships that are the real issues.
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  The notion that the U.S. is declining in nominal terms is readily dismissed by Nye. "Imperial overstretch" concepts are also untenable due to the steady and substantial reduction in the nation's relative military and foreign policy burdens over time. As a percentage of GDP, these burdens continue to decline. (However, the overall economic burden of government expenditures is massively increasing as a percentage of GDP and visibly impacts the resources available for military and foreign policy.)
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There is clear resentment in China over the continuing frustration of its ambitions in its peripheral seas. China's military buildup is specifically designed to make it impossible for the U.S. to project naval power into these areas of potential conflict.

  Clearly, if there is a great power conflict in the first half of the twenty-first century, it will be between China and the U.S., either over Taiwan or Chinese ambitions in the South China Sea or the seas off Eastern China. There is clear resentment in China over the continuing frustration of these ambitions. China's military buildup is specifically designed to make it impossible for the U.S. to project naval power into these areas of potential conflict.
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  Nye properly casts a skeptical eye upon the facile efforts to find historic analogies.

  "Context, scope, and domain must be specified, and there is the danger of allowing the golden glow of the past to color the appraisal of history. Vague definitions and arbitrary history should cause us to be wary of grand theories of hegemony and decline."

  Declinists have been a feature in American intellectual circles since Revolutionary War days, Nye points out. In the 1950s and 1960s, socialism was viewed as the wave of the future and the Soviet Union would bury the U.S. Runaway inflation followed by a series of oil shocks, severe recession and decline of rust belt industries supported the view in the 1980s that the U.S. was in absolute decline. However, by the 1990s, the U.S. was suddenly the predominant - indeed the only - world superpower. With the advent of the Credit Crunch recession, the declinists are back in full cry.
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Only China is likely to be pose an active hard power or soft power threat to the Western system.

  Nye compares U.S. power resources and their prospects with those of Europe and Japan and the "BRICs" - Brazil, Russia, India, and China. Of these, only China is likely to be pose an active significant hard power or soft power adversary for the Western system. (Indeed, it is already a serious soft power counterweight amongst developing and undeveloped nations. See, Brimmer, "The End of the Free Market.")
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  Europe's lack of cohesion undermines much of its "power-conversion" capability, but for many purposes, Europe's soft power capabilities have proven impressively formidable. Aside from the projection of military power, the world is currently in bipolar balance between the U.S. and the EU. Most important, Nye points out, European power supports rather than threatens U.S. interests and power and is a force for stability. Japan, too, is likely to remain an ally of the U.S.
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  Russia is currently a declining power even though it has recouped some of its strength since its collapse during the 1990s. It still lacks the institutional foundations of a modern economic and world power and is woefully weak in soft power potential. It has recently moved more closely to China in several ways, but has inherent fears of the growing power of its huge neighbor - and a huge population imbalance across its Siberian border that supports fear that Siberia may eventually slip into Chinese hands. Brazil and India continue to be constrained by major economic policy weaknesses and are unlikely to achieve more than local power status in this century. Their interests are not in major conflict with U.S. interests, and China's support for Pakistan limits Chinese influence in India. Thus, only the part of Nye's analysis involving China is of interest here.
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China:

 

 

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  China's "market Leninist" economic and political policies are attractive and a source of important support for emerging market and stagnant autocracies. See, Halper, "The Beijing Consensus." However, those policies can be a huge embarrassment for China's relations with democratic nations and international NGOs.
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  Nye warns that expectations of the inevitability of U.S. - China conflict can become a self-fulfilling prophecy as both sides ramp up military preparations.
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  China's economic transformation has been a huge success but still leaves many economic policy obstacles that will obstruct its success in the future. (Indeed, the pace of reform seems to have recently slowed significantly and may in some vital respects have reversed, as described by Walter & Howie in "Red Capitalism, reviewed in "Prospects for China's Power and Influence," below.) Nye points out why simple GDP equivalence would still leave China well short of U.S. economic strength and prospects.

  "China would still have a vast underdeveloped countryside, and it will begin to face demographic problems from the delayed effects of the one child per couple policy it enforced in the twentieth century. Newcomers to China's labor force will start declining in 2011, and China's labor force will peak in 2016. Moreover, as countries develop, there is a tendency for growth rates to slow. If we assume a 6 percent Chinese growth and only 2 percent American growth after 2030, China would not equal the United States in per capita income until sometime in the second half of the century."
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  "Moreover, linear projections of economic growth trends can be misleading. Countries tend to pick the low-hanging fruit as they benefit from imported technologies in the early stages of economic takeoff, and growth rates generally slow as economies reach higher levels of development. - - - In addition, the Chinese economy faces serious obstacles of transition from inefficient state-owned enterprises, growing inequality, massive internal migration, an inadequate social safety net, corruption, and inadequate institutions that could foster instability. - - - Almost alone among developing countries, China is aging fast. By 2030, China will have 'more elderly dependents than children.'"

  Nye reminds us of the gross inaccuracy of such linear projection analyses when they were uncritically applied to Soviet Union power prospects. (In the 1980s, many believers in "industrial policy" expected Germany and Japan to become the predominant economic powers.)
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    The severe and growing economic distortions caused by China's industrial policy and mercantilist policies receive appropriate attention by Nye. He points out that China's export-led growth model is unsustainable since it would require a doubling of China's share of world exports to sustain an 8% economic growth rate through 2020. Industrial policy limits competition in major economic sectors in favor of the politically influential. Its banking and financial system remains opaque and highly subservient to government policy.

  State-owned enterprises are now actually expanding and political influence over major private businesses is now actually increasing. China will trip up over its economic distortions well before 2030. However, as long as China' vibrant competitive private sector maintains China's handsome balance of payments surplus, these distortions will cause economic problems rather than economic disasters.

Corruption is inherent in the Chinese system and is growing, and legitimacy is uncertain.

  The legitimacy of the Chinese Communist Party currently rests on economic growth and ethnic Han nationalism. Corruption is inherent in the system and growing, and legitimacy is uncertain.

  "Whether China can develop a formula that can manage an expanding urban middle class, regional inequality, and resentment among ethnic minorities remains to be seen. The basic point is that no one, including the Chinese, knows how China's political future will evolve and how that will affect its economic growth."

  That China will be able to draw increasing resources for military and other policy purposes from its growing economy regardless of continuing poverty levels is appropriately acknowledged by Nye. He also appropriately points out that China's military interests are concentrated in the South China Sea and similar regional areas around its borders while the U.S. is spread thin across the globe.

  Nevertheless, a glaring weakness of Nye's analysis is his use of military spending as the measure of national military capability. This is grossly simplistic and of practical use predominantly for propaganda and obfuscation. For example, the only part of U.S. military spending of interest to China is that small portion that supports the U.S. ability to project power into the Western Pacific, the South China Sea and the Indian Ocean. Similarly, this is all that matters to China's worried neighbors from South Korea all the way around to India. A similar analysis applies to Europe and the Middle East.

  Nye sums up with an excellent evaluation of the current and prospective power relationships in the eastern and southern Asian region.

  "That China is not likely to become a peer competitor to the United States on a global basis does not mean that it could not challenge the United States in Asia, but - - - the rise of Chinese power in Asia is contested by both India and Japan -- as well as other states --, and that provides a major power advantage to the United States. The U.S. Japan alliance, which the Clinton-Hashimoto declaration of 1996 reaffirmed as the basis for stability in post-Cold War East Asia, is an important impediment to Chinese ambitions, as is the improvement in U.S.-Indian relations that advanced under the Bush administration. This means that in the great power politics of the region, China cannot easily expel the Americans. From that position of strength, the United States, Japan, India, Australia, and others can work to engage China and provide incentives for it to play a responsible role, while hedging against the possibility of aggressive behavior as Chinese power grows."

The prospects for U.S. power resources:

 

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  Nye finds no evidence of decline in U.S. cultural attractiveness despite declinist perceptions to the contrary. Cultural problems like crime, intolerance, divorce, and teenage pregnancy actually show substantial improvement. Existing problems are naturally exaggerated by the media. On balance, U.S. culture continues to be a very attractive attribute.
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  The U.S. remains a very attractive destination for immigrants. Nye properly stresses the many advantages of immigration.

  "That people want to come to the United States enhances America's appeal, and the upward mobility of immigrants is attractive to people in other countries. America is a magnet, and many people can envisage themselves as Americans. Many successful Americans 'look like' people in other countries. Moreover, connections between immigrants and their families and friends back home help to convey accurate and positive information about the United States. In addition, the presence of multiple cultures creates avenues of connection with other countries and helps create an important broadening of American attitudes in the era of globalization. Rather than diluting hard and soft power, immigration enhances both."

  The elections of President Obama and Governor Schwarzeneger constitute significant inherently credible soft power messages that command widespread attention.

  Economic prospects, however, are critical to all other power characteristics. Widespread expectations for slow economic growth in the decade following the Credit Crunch recession provide cause for concern. Nye views such projections with suitable skepticism based on past performance, but provides at best just a cursory effort at evaluating the pertinent factors.
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  The last period of similar pessimism about U.S. economic prospects flowed naturally out of the 1970s. Nye reminds us that such pessimism was proven spectacularly wrong.

  Not just coincidentally, the 1970s were the last period of Keynesian inflationary morass - which didn't end until the Keynesians were kicked out of Washington and Paul Volcker had the time and opportunity to repair the damage caused by two decades of artificially low interest rates and rapid monetary inflation. Now, the U.S. is in a second period of Keynesian inflationary morass, artificially low interest rates and rapid monetary inflation with similar economic results.

  Nye correctly highlights the continuing superiority of U.S. competitiveness, innovativeness, flexibility, rates of productivity growth, entrepreneurship and application of commercial technologies. Less convincing is Nye's evaluation of the seriousness of the nation's debt and entitlement problems. He properly notes the advantages of the reserve currency status of the dollar and deep and reliable U.S. financial markets. However, this leads him to conclude that the debt and entitlement problems need not cause decline but merely increase the risks of decline.

  Nye offers no recognition that:

  • States following Keynesian policies are invariably declining states;
  • States with substantial rates of monetary inflation are invariably declining states;
  • States with major welfare entitlements are invariably declining states; and,
  • States with long periods of artificially low interest rates are invariably financially unstable and ultimately in decline. Interest rates play many roles in market systems that are absolutely essential for maintenance of economic health and stability within a normal business cycle

  The answer to U.S. economic decline is once more to kick the Keynesians out of Washington and dismiss Bernanke and similar people from the Federal Reserve. However, now, it is also essential to impose robust cost caps on entitlement obligations. Nye seems oblivious to the fact that both economic and military power decline is inevitable without this change in policy. The economic pain and political difficulty of such a change in policy always raises the question of whether the nation can, as in the 1980s, find the necessary leadership.

  An  evaluation of political trends, their complexities and impacts on U.S. power relationships is provided by the author. The disparate, sometimes tumultuous political environment and its sometimes dysfunctional impacts on foreign policy - especially when enshrined in Congressional legislation - is unfortunately nothing new and something the U.S. - and the world - will simply have to continue to accommodate. The multiple strengths and the resiliency inherent in a system based on a mature civil society that is politically, economically and legally empowered is generally overlooked by declinists and most pundits. The views of political and societal decay are clearly myopic.

  Those who underestimate the resiliency, flexibility, entrepreneurial drive and innovativeness of the U.S. economy and the capacity for self renewal of its political system demonstrate incredible ignorance. As demonstrated in the 1980s and 1990s, all it takes for economic recovery and restoration of normal business cycle levels of stability and growth is the restoration of some sanity in government regulatory, budgeting and monetary policies.

  A perceptive, brief "net assessment" is provided by Nye.

  "China's size and high rate of economic growth will almost certainly increase its relative strength vis--vis the United States. This will bring it closer to the United States in power resources but will not necessarily mean that China will surpass the United States as the most powerful country. Even if China suffers no major domestic political setback, many current projections based on GDP growth alone are too one-dimensional and ignore U.S. military and soft power advantages, as well as China's geopolitical disadvantages in the internal Asian balance of power compared to America's likely favorable relations with Europe, Japan, India, and others."

  U.S. power and influence "is based on alliances rather than colonies," and "an ideology that is flexible," Nye correctly points out. Unlike past great powers, it is not tied to imperial burdens and is welcoming to change where others were tied to a status quo.

  "America is not in absolute decline, and it is likely to remain more powerful than any single state in the coming decades, although American economic and cultural preponderance will become less dominant than at the beginning of the century. At the same time, the United States will certainly be faced with a rise in the power resources of many others -- both states and nonstate actors. The United States will also face an increasing number of issues in which solutions will require power with others as much as power over others. American capacity to maintain alliances and create networks will be an important dimension of the nation's hard and soft power."

Strategy and tactics:

  "Smart power" is the term Nye uses for the proper strategy and tactics of modern power relationships.
 ?

The U.S. is likely to remain the most powerful player with the most important leadership role. Smart power considerations will be increasingly important for U.S. foreign policy. Success will increasingly depend on how it manages its alliances and relationships.

  It is a three dimensional chess game as he described in his previous work. It involves multiple players and shifting alliances that increases in complexity as major emerging market states increase in relative economic, military and soft power resources. The U.S. has actually never been dominant in all aspects of this game.
 ?
  The U.S. has possessed preponderant power for a century, but fought all its wars during the previous 100 years with alliances and relationships that were vital to its success. The 21st century will continue to be a period of "power diffusion" characterized by the "rise of the rest." However, the U.S. is likely to remain the most powerful player with the most important leadership role. Smart power considerations will be increasingly important for U.S. foreign policy, the author emphasizes. Success will increasingly depend on how it manages its alliances and relationships.
 ?

  Policy begins with definition of the nation's broad strategic objectives. The grand strategy agenda bulges with objectives ranging in importance from existential to general concern. These are reflections of the nation's interests and values in a bewildering array of contexts. It includes the traditional imperatives of national military and economic security and then extends through important international objectives - including secure national borders, freedom of the seas, open trade, control of infectious diseases, stability of financial markets and environmental concerns. Some of these are universal "public goods" that benefit all, while others are "club goods" that benefit the U.S. and cooperating nations.
 ?
  Nye raises the vital question as to whether a rising China will play a positive, passive or obstructive role in international affairs. (So far, the omens are not propitious.)
 ?
  Nye includes climate change, preservation of endangered species, uses of outer space and cyberspace as 21st century global commons concerns. Peacekeeping and promotion of human rights justify considerable extension of soft power resources, as does development of international institutions and regimes for law for particular purposes such as trade, the environment and nuclear proliferation.
 ?
  The importance of encouraging economic development in impoverished undeveloped nations is emphasized by Nye, but he acknowledges the futility of aid in the face of kleptocratic governance and pervasive corruption. Of course, the U.S. should continue to broadly extend its diplomatic good offices for the mediation of international and internal conflicts.
 ?

The U.S. attractive force as "the shining city on the hill" epitomizing political and economic freedom and individual liberty, along with a vibrant culture, remain powerful assets.

  While overall U.S. military supremacy will probably last well into the century, Nye realistically acknowledges that it can already be challenged in "contested zones" such as foreign airspace as high as 15,000 feet, urban areas where air defenses are concentrated and targets are mixed in with civilian populations, remote regions, and littoral seas such as those near China. Counter insurgency operations by their very nature pose special difficulties and great costs that impose limits in terms of engagement and time.
 ?
  The U.S. attractive force as "the shining city on the hill" epitomizing political and economic freedom and individual liberty, along with a vibrant culture, remain powerful assets. While still strong economically, however, U.S. economic strength has been battered this last decade.
 ?

"Global leadership does not require global interventionism."

 

The U.S. must be mindful that even its financial resources are not infinite, and wars of financial attrition can break its economic strength.

  The current conflict in Iraq, Nye points out, united America's enemies and divided its friends. It greatly aided jihadist recruitment and stimulated a great increase in terrorist attacks.
 ?
  The difficult balancing act between use of hard and soft power instruments in particular contexts will remain a constant concern. The author provides examples from African and Latin American policy. He discusses the nebulous nature of soft power instruments and the difficulties of implementation and evaluation. Soft power instruments like public diplomacy, broadcasting, exchange programs, development assistance, disaster relief, military-to-military contacts (such as apparently proved so useful in the peaceful outcome of the uprising in Egypt), are uncoordinated and lack any over-arching strategy. They frequently lack any effort to coordinate them with hard power instruments. Smart power considerations demand coordination and integration of all power instruments used in foreign power strategy. (Counterinsurgency operations in Iraq and Afghanistan now actively include coordination with substantial soft power initiatives.)
 ?
  The strategic insights of President Eisenhower are emphasized by the author. He urges a return to the "traditional prudence" of Eisenhower's foreign policy. "Global leadership does not require global interventionism." Avoiding land wars in Asia now looks like a particularly appropriate Eisenhower warning. The U.S. must be mindful that even its financial resources are not infinite, and wars of financial attrition can break its economic strength.

  "Also relevant today is Eisenhower's belief that it is essential to preserve the strength of the American economy that undergirds military strength." (The further we get from the partisan sniping of the 1950s, the better Eisenhower looks and the higher he rises in the historic rankings of U.S. presidents.)

  That American troops are welcome in such places as South Korea, Japan and Europe makes projection of military power in such places highly cost effective.

  This constitutes confirmation that U.S. soft power remains at levels beyond that of any other predominant power in world history. Along with the continuing desire of people to migrate to the U.S. - to vote for the U.S. with their feet - the widespread acceptance of the U.S. military presence abroad serves to counter the most vicious anti-American propaganda.

  However, there are limits to both power resources and public support for any substantial commitment of power resources. The smart power strategy and narrative for the 21st century must be based on the "pragmatic tailoring of the foreign policy garment to the foreign power cloth."

  "Preponderance is not empire or hegemony. The United States can influence but cannot control other parts of the world. Power always depends upon context, and in the context of international relations -- such as climate change, illegal drugs, pandemics and terrorism --, power is diffuse and chaotically distributed. Military power is a small part of the solution in responding to these new threats."

  The U.S. cannot succeed alone. It will always be dependent on finding partners and on "maintaining old alliances as well as developing new networks that involve emerging powers such as China, India, and Brazil."
 ?

Immediate tactical challenges include terrorism, nuclear proliferation and access to nuclear materials by terrorists, and support for moderate Muslims in their current civil war with radical Islam. Nye advises support for expansion of free trade to enable economic growth, the development of civil society and gradual democratization around the world..

  Primary strategic objectives include security for the U.S. and its allies, maintenance of economic strength and international economic stability, avoiding environmental disasters, "and encouraging liberal democracy and human rights at home and abroad where feasible at reasonable levels of cost." This last objective is best pursued through patient application of the attractiveness of soft power - of our "shining city on the hill" image.
 ?
  Immediate tactical challenges include terrorism, nuclear proliferation and access to nuclear materials by terrorists, and support for moderate Muslims in their current civil war with radical Islam. Nye advises support for expansion of free trade to enable economic growth, the development of civil society and gradual democratization around the world.
 ?
  Relations with China present another serious tactical challenge. China must be encouraged to become "a responsible stakeholder," but the U.S. must retain relations with China's neighbors as a hedge against conflict.

  The U.S. is still and will indefinitely remain the predominant world power even as major emerging nations gain in relative strength. There is not one of them that will not trip over severe economic distortions in the next few decades. Whatever its past successes and failures, its wise policies and foolish policies, the U.S. remains "the last best hope for mankind." It must not abandon that responsibility lest the world again descend into chaos as it did in the 1920s and 1930s, the last period when the U.S. turned inward.

Prospects for China's Power and Influence.

Limitations on China's economic prospects:

  China's rulers are not ten feet tall. Their economic policies impose severe distortions on the Chinese economy that limit China's economic prospects. See, China's Economic Prospects, with a review of McGregor, "The Party."
 ?

Because of its shear size, China will achieve massive economic power under any kind of market capitalist system. The projections as to the extent of China's growth, however, depend crucially on further economic liberalization that at present seems to have stalled and in some vital respects, has recently been thrown into reverse.

 

It is the private sector that is competitive and vibrant, export oriented and growing, and accounts for the vast majority of China's export earnings and massive balance of payments surplus.

 

The ultimate policy making authority in these companies resides in the Party cells rather than in the boards of directors.

  In "Red Capitalism," Walter and Howie set forth in some detail the nature of the distorting economic policies of the Chinese Communist Party. They provide much interesting detail about the historic evolution of the economic transformation process and considerable texture to the elements only broadly set forth below in this article.
 ?
  China will, indeed, continue to increase in economic power for some time to come as it continues to leave the constraints of socialism behind and continues to take advantage of its huge pool of cheap unused labor. Because of its shear size, it will achieve massive economic power under any kind of market capitalist system. The projections as to the extent of China's growth, however, depend crucially on further economic liberalization that at present seems to have stalled and in some vital respects, as set forth by the authors, has recently been thrown into reverse.
 ?
  China has an autocratic capitalist market economic system with a large and currently growing state capitalist segment.  Ruled by a Leninist political party, it is an extreme version of autocratic capitalism. It is far more extensively autocratic and less market oriented than Singapore, for example, but far more subject to competitive disciplines than many other examples of this economic genre.
 ?
  However, it is the private sector that is competitive and vibrant, export oriented and increasingly profitable, and accounts for the vast majority of China's export earnings and massive balance of payments surplus. The state owned enterprise ("SOE") segment is still somewhat more than half the economy and comprises all the major financial and industrial segments. It is no longer being seriously subjected to economic reforms or the pressures of market competition. It is increasingly responsive primarily to the political agenda of the Chinese Communist Party rather than to market pressures. It currently functions predominantly as an arm of the Party for the achievement of Party objectives, regardless of shareholder interests, and as a vehicle through which the Party and its members and political favorites milk financial resources from the Chinese economy.
 ?
  Major Chinese companies are being listed on Western securities exchanges. However, investors must understand that the ultimate policy making authority in these companies resides in the Party cells rather than in the boards of directors. The Party cells control appointments to top management positions and may even direct business policy regardless of shareholder interests when that is in the perceived interests of the Party. (If the companies have Chinese auditors accredited only by Chinese accrediting agencies, the books and records must be viewed with suspicion.)
 ?

The financial system:

  China's major banking institutions dominate China's financial system. They are dedicated to the financial needs of the state owned enterprises, national and local governments, and the Party. The private sector gets little if any support.
 ?

The banks cover up their growing weaknesses by shunting non-performing loans into off-balance-sheet entities. These entities are independent in name only since the money used to establish them and pay for the non-performing loans is provided by the banks.

 

The rigidly constrained financial system undermines prospects that the yuan might achieve hard currency status sufficient to compete with the dollar.

  The banks prop up the SOEs with massive loans that frequently are defaulted. The SOEs are too politically influential to be forced to pay up or be forced into bankruptcy. The banks are expected as a matter of government policy to continuously roll over all manner of debt extended to local governments and SOEs, so these loans really never have to be repaid. The banks also need never mark debt securities to market value since the securities are generally held to maturity and then rolled over and, in any case, there is no real market price.
 ?
  The banks cover up their growing weaknesses by shunting non-performing loans into off-balance-sheet entities. These entities are independent in name only since the money used to establish them and pay for the non-performing loans is provided by the banks. The receipts of repeated public share offerings by the banks have recently almost all been used to maintain their dividends. This whole Alice in Wonderland accounting system, however, is propped up by the massive rate of savings of the Chinese people that has nowhere else to go, and is ultimately backstopped by China's massive balance of payments surplus and resulting trillions of dollars in reserves.
 ?
  The authors point out that this system can only be maintained behind the walls of a non-convertible currency. The rigidly constrained financial system undermines prospects that the yuan might achieve hard currency status and utility as a reserve currency sufficient to compete with the dollar.
 ?

Financial markets are thus just another mechanism for bank financing for government and SOE purposes.

  China has a growing bond and commercial paper market that includes all the other financial and regulatory instruments of modern finance. These debt-capital markets ostensibly provide an alternative to bank financing for both government entities and major SOEs, but interest rates are set by the People's Bank of China to conform to prevalent bank lending rates. Thus, there are few investors other than the banks and other government dominated institutions, and very little volume in the trading markets.
 ?
  The banks now hold 70% of the bonds in value terms and SOEs hold the vast majority of the rest. These securities are generally held to maturity, so there is no price discovery function in these markets and no realistic time cost of money to guide economic planning. These financial markets are thus just another mechanism for bank financing for government and SOE purposes.

  "In other words, the banks provided the government with direct access to household deposits at government-imposed interest rates without even having to ask the depositor for permission: the banks simply disintermediated them. Unlike unruly retail investors seeking to maximize returns, banks had the pleasing aspect that their senior management -- Party members -- did as they were told. The Party was now easily able to direct funds where it wanted and in the amount it wanted without the need for excessive cajoling or paying market rates. Meanwhile, it could persuade itself that this was the right thing to do since it 'protected' the household depositor from undue risk."

  Does this sound to you like the Social Security System? It remains attractive to the government as long as Social Security tax receipts exceed Social Security payments. Indeed, all entitlements are attractive to the government as long as their tax receipts exceed program payments - which for most will not last much longer. The "trust funds" are, of course, a convenient accounting fiction - like those off balance sheet entities into which the Chinese banks funnel their non-performing loans. Alice in Wonderland accounting is not confined to government entities in China.

  The sterilization of balance of payments inflows to keep down the exchange rate of the Chinese currency is also facilitated by the captive debt-capital markets. By issuing short term securities to the banks and SOEs, the People's Bank of China sops up the vast increases in the money supply otherwise caused by the balance of payments surplus. These vast reserves have been channeled into the Chinese sovereign wealth fund  - the "China Investment Corporation" - controlled by the Ministry of Finance which has thus gained financial control of China's major banks and in many respects has now surpassed the People's Bank of China as the predominant financial policy agency in China.

  "Protectionist measures, controlled exchange rates and fixed lending spreads ensure the Party's control and the stability of the system, and virtually guarantee that the banks must raise new capital every few years to prime the cycle. Viewed from the outside, bank profits reassure retail depositors that their banks are sound and their deposits safe. International investors support bank shares since they are seen as proxies of a bank-driven GDP number. The banks use household deposits and new equity capital to fund new loans to drive GDP and to support the conceit that is China's debt-capital market, which sustains the appearance of overall convergence toward a Western-style market system.
 ?
  "Instead of removing the risk burden from the banks, China's backward bond markets create new risk. Making up around 30 percent of the total assets of the Big 4 banks, these 'investment' portfolios enjoy negative interest spreads, leaving banks exposed to significant market risk. More asset bubbles, stock-market booms and problem loans are the inevitable product of this arrangement."

Industrial policy:

 

 

 

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  China's stock markets have been used by the Party as a mechanism to gather up the bits and pieces of its Mao era SOEs and concentrate its major industries and utilities into "National Champions" that it can control and manipulate at will. The authors note that Western investment bankers like Goldman Sachs and Morgan Stanley provided the financial expertise for the mergers and acquisitions process. As a result, China's SOEs are now more than ever concentrated and characterized by monopolies and oligopolies.
 ?

  The stock markets are about power rather than about finance. Stock issuances are typically used openly to reward powerful state entities and the politically influential rather than to raise investment funds. Valuations are deliberately set low so prices will rise to reward those allocated some of the new stock. That this short changes the issuing company is of no concern, since needed financing is predominantly obtained from the banks.
 ?
  China's stock markets in Shanghai and Shenzhen are state of the art in all respects, heavily traded and capable of raising huge sums. However, that is just a surface veneer. The Party controls the ownership of all the major listed companies. Only a handful of the private companies listed are of any substantial size, and these are generally confined to "such areas as consumer, food, certain areas of hi-tech, pharmaceutical and other light industrial sectors" of little consequence to the Party.

  "China's stock exchanges are not founded on the concept of private companies or private property; they are based solely on the interests of the Party. Consequently, despite the infrastructure, the data and all the money raised, China's stock markets are a triumph of form over substance. They give the country's economy the look of modernity, but like the debt-capital markets, the reality is they have failed to develop as a genuine market for the ownership of companies."

  The speculative aspects of the markets thus predominate.  It is in China that the stock markets are mere casinos.

  "In China, the stock and real-estate markets have evolved into controlled outlets for surplus capital seeking a real return and, for the most part, this capital is controlled by agencies of the state. Stocks and real estate are the only two arenas in China that, although subject to frequent administrative interference, can produce rates of return greater than inflation."

  The authors sketch the origination and evolution of China's securities markets from their modest beginnings in the 1980s. They were established despite sometimes fierce ideological opposition within the Party. There was simply no other way within China to raise large amounts of capital for large scale industry.
 ?
  Capital from domestic stock markets was substantially supplemented in the 1990s when enterprises were permitted to list in Hong Kong and Western stock markets. By 2009, about $262 billion had been raised in international markets.

  "If there is a single reason why the world is in awe of China's economic miracle today, it is because international bankers have worked so well to build its image so that minority stakes in its companies could be sold at high prices, with the Party and its friends and families profiting handsomely."

  The two major stock markets were designed in the 1990s to end the free securities markets that had sprung up around China. They concentrated market activity where it could be controlled and used by the Party to raise funds for the SOEs. Funds from international investors were attracted in massive amounts to provide the wherewithal to assemble scattered industrial and financial firms into concentrated "National Champions" controlled by Beijing.

  "Over the period 1997-2006, bankers and professionals from a small number of international legal and accounting companies played major roles in the creation of entire new companies. These companies were created out of industries that were fragmented, lacking in economies of scale, or, in the case of the banks, even publicly acknowledged as being bankrupt. - - -
 ?
  "Simply put, international finance, legal and accounting rules provided the creative catalyst for China's vaunted National Team. Even more important, their professional expertise and skills put Beijing and the Communist Party of China in the driver's seat for a strategic piece of the Chinese economy for the first time ever: the central government and the Party's Organization Department own the National Team."

The National Team:

 

?

  The National Team comprises the industrial and financial heights of the Chinese economy. The senior officials of National Champion industries are appointed from among ministerial level Party functionaries, thus combining political power with economic power.
 ?

From their commercial power bases, National Champion senior officials have come to dominate the Party itself.

  The old Soviet-style planning ministries were no longer needed and were drastically reduced in size, function and influence. They ultimately disappeared into the insignificant State Economic and Trade Commission.
?
  From their commercial power bases, National Champion senior officials have come to dominate the Party itself (exactly as Hayek would have expected).

  "Allowing the senior management of the SOEs to retain their respective ranks within the Party nomenklatura after the dissolution of the ministries, however, created a fissure within the Party and government along business and political lines. In some sense, this was a pre-existing split in that families and friends of senior leaders had actively engaged in their own businesses since at least the  early 1990s. But it is no longer simply a case of the sons and daughters of the rich and famous being out in the market selling influence. With access to huge cash flows, broad patronage systems and, in many cases, significant international networks, the senior executives of the National Champions can expect to succeed in lobbying the government for beneficial policies or even to set the policy agenda from the start. The sons and daughters and families now have institutional backing outside of the Party itself and this gives rise to questions over whether these business interests have, over the past decade, replaced the government apparatus, or eroded the government from within. How accurate is the statement that 'The business of China is business' and is this beneficial in a system of communist-style capitalism?"

  Recent efforts to regain political control under the State-Owned Assets Supervision and Administration Commission have proven ineffective since Chairmen/CEOs of National Champion firms outrank the bureaucratic officials as Party officials. A government entity cannot "exercise authority over enterprises whose senior management has been appointed" by the Party and who report directly to the Party.

  "The profit made by these nominally state-owned enterprises is not small and in recent years has reached almost 20 percent of China's national budget expenditures - - -. This is a vast amount of money that would be better redirected at the country's burgeoning budget deficit. Instead, because of their political and economic power, coupled with the ingenious argument that they continue to bear the burden of the state's social-welfare programs, the National Champions are able to retain the vast bulk of their earnings. The fact that the government is not able to access this capital is the best illustration of the power of these oligopolies."

  The banks remain a significant exception. Despite their clout, the Big 4 banks remain classified as only vice-ministerial entities.

  "An entity is placed in the state organization hierarchy based on the rank of its highest official; the chairman/CEO of these banks carry only a rank of vice-minister. The reason for this exception appears to be straightforward: the Party seems to have wanted to ensure that the banks remained subordinate entities, and not just to the State Council, but to the major SOEs as well. Banks were a mechanical financial facilitator in the Soviet system: the main focus of economic effort then was on the enterprises. Little has changed."

The authors explain how the National Champions are used as institutions of crony capitalism and how the domestic Chinese stock markets are manipulated in favor of the Party, the National Champions and other SOEs and the politically influential.

 

"The state is involved at every stage of the market as the regulator, the policymaker, the investor, the parent company, the listed company, the broker, the bank and the banker. In short, the state acts as the staff for China's major SOEs."

  The National Champion industries increasingly conduct business in their own self interest. The authors explain how they are used as institutions of crony capitalism and how the domestic Chinese stock markets are manipulated in favor of the Party, the National Champions and other SOEs and the politically influential.

  "In this business environment, the National Champions, their family associates and other retainers plunder the country's large domestic markets and amass huge profits. With nationwide monopolies or, at worst, oligopolies, these business groups do not want change, nor do they believe that foreign participation is needed."

  Initial public offerings are used not to raise capital but to redistribute capital among the state agencies and other SOEs who are allotted the vast majority of under-priced IPO shares and reap the rewards from the immediate price rise in the aftermarket. Aftermarket participation is vigorous - even feverish - despite being influenced more by politics than profit. As casinos without legitimate business purpose, money can still be made. Interest rates are kept artificially low to favor state borrowers, so yields are unattractive. Thus, the stock markets and real estate are the only ways to make a real return above inflation rates.

  "The Chinese market simply doesn't have natural stock investors: everybody is a speculator. Chinese history and bitter experience teach that life is too volatile and uncertain to take the long-term view. The natural result of this is a market dominated by short-term traders, all dreaming of a quick return. The one natural investor is the state itself and it already owns the National Champions."

  Market performance is generally decoupled from actual economic performance. Chinese investors buy shares because they think the shares are going up, regardless of economic or company performance.
 ?
  Party/National Champion officials control every aspect of this game. Thus, China's economic transformation - the reason for its great economic success during these last few decades - has probably come to an end.

  "The state is involved at every stage of the market as the regulator, the policymaker, the investor, the parent company, the listed company, the broker, the bank and the banker. In short, the state acts as the staff for China's major SOEs. With the National Team formed and with its senior management being coterminous with the very center of political power, can there be any true reform of corporate governance? Is it likely that they would accept the creation of a Super Regulator with real authority over the market and their own conduct?"

  Chinese accredited auditors are now accepted by Hong Kong. The Chinese accrediting agencies will not view with pleasure any audits that criticize the books and records of any of the National Champions. Indeed, major Chinese industries no longer list with Western stock exchanges and many are retreating to Hong Kong and the domestic markets.

  Some Chinese companies that have Chinese auditors have gained access to Western - and U.S. - securities markets by arranging to be bought by shell companies that have stock market listings. Western regulatory agencies are beginning to find troublesome defects in the books and records of these companies.

  The government and the Party:

 

?

  The Byzantine power structures of the Party and the government,  with their bureaucratic systems and infighting, is described by the authors and is well worth reading by those who wish a better understanding of modern China and its power prospects.
 ?

  Only a strong premier or party secretary can coordinate such activity to ensure it is in line with the Party's general goals; only they can channel the energies of government and Party leaders and minimize costs.

  "The absence of a strong leader is a weakness that allows the special-interest groups to take advantage. A vice-premier in charge of finance may understand his remit, but unless he has the ear of the general secretary, it is to no avail. A central bank governor may know clearly the critical issues across the financial maze, but unless he is supported, political compromise will trump all else. On the other hand, for the National Team, the less scrutiny there is, the better."

  The increasingly shaky state of China's complex financial arrangement is amply demonstrated by the authors. They lump the official government debt together with the debts of government policy agencies, local governments, and the non-performing loans of the SOEs in estimating total government debt burden for China at almost 80% of GDP.

  "This burden can only increase, given China's practice of generating a significant portion of GDP growth through fixed asset investment. Others will arrive at different estimates. The point is simply that in the past few years, China has quickly built up significant levels of public debt, and that is without taking the value of contingent liabilities, such as social security obligations, into consideration."

  Nevertheless, a rapidly growing economy can always outgrow even the largest debt burdens. Moreover, as long as the vibrant private half of China's economy continues to provide China with a substantial balance of payments surplus, China's trillions of dollars in reserves will provide the resources China needs to absorb the losses and the dodgy finances of the government owned and dominated sector of its economy. And, China's state-controlled banks will continue to gather the nation's substantial domestic savings for use by government agencies, SOEs and the politically influential.
 ?
  As the authors point out, practically all of this debt is held not just domestically but by the members of the National Team, and lending decisions are made for the benefit of the borrowers, not the lenders. However, these dodgy industrial policy and financial mechanisms must at some point impose substantial limitations on China's economic prospects. Uncritical straight line growth projections will prove as false for China as they generally have for other newly emerging nations.

  Increasing pension and social security obligations and any substantial increase in interest rates forced by rising inflation in this funny-money system threatens to undermine this vast debt structure. The central bank has already shown a preference for reliance on increases in bank reserve requirements as an inflation control mechamism. (However, there is no substitute for rising interest rates as an inflation control method, and China's interest rates perforce have recently been tentatively allowed to rise in response to surging rates of price inflation.)

  "In sum, China's growing dependence on debt to drive GDP growth implies that there will be no meaningful reform of interest rates, exchange rates or material foreign involvement in the domestic financial markets for the foreseeable future. Nor will there be any further meaningful reform or internationalization of the major banks, although future recapitalizations will inevitably take place."

  The dot-com bust and Credit Crunch financial crisis have discredited Western financial concepts. They support the revival of Party interests that favor central planning and economic control in a closed system of vast monopoly and duopoly enterprise. They may also have subverted Party policy to the interests of the powerful officials who head the National Champion SOEs. (However, even the Party will eventually have to face the fact that the markets ultimately always win - viciously!)

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