Richard Rosecrance. Foreign Affairs. Volume 75, Issue 4. July/August 1996.
Territory Becomes Passe
Amid the supposed clamor of contending cultures and civilizations, a new reality is emerging. The nation-state is becoming a tighter, more vigorous unit capable of sustaining the pressures of worldwide competition. Developed states are putting aside military, political, and territorial ambitions as they struggle not for cultural dominance but for a greater share of world output. Countries are not uniting as civilizations and girding for conflict with one another. Instead, they are downsizing-in function if not in geographic form. Today and for the foreseeable future, the only international civilization worthy of the name is the governing economic culture of the world market. Despite the view of some contemporary observers, the forces of globalization have successfully resisted partition into cultural camps.
Yet the world’s attention continues to be mistakenly focused on military and political struggles for territory. In beleaguered Bosnia, Serbian leaders sought to create an independent province with an allegiance to Belgrade. A few years ago, Iraqi leader Saddam Hussein aimed to corner the world oil market through military aggression against Kuwait and, in all probability, Saudi Arabia; oil, a product of land, represented the supreme embodiment of his ambitions. In Kashmir, India and Pakistan are vying for territorial dominance over a population that neither may be fully able to control. Similar rivalries beset Rwanda and Burundi and the factions in Liberia.
These examples, however, look to the past. Less developed countries, still producing goods that are derived from land, continue to covet territory. In economies where capital, labor, and information are mobile and have risen to predominance, no land fetish remains. Developed countries would rather plumb the world market than acquire territory. The virtual state-a state that has downsized its territorially based production capability-is the logical consequence of this emancipation from the land.
In recent years the rise of the economic analogue of the virtual state-the virtual corporation-has been widely discussed. Firms have discovered the advantages of locating their production facilities wherever it is most profitable. Increasingly, this is not in the same location as corporate headquarters. Parts of a corporation are dispersed globally according to their specialties. But the more important development is the political one, the rise of the virtual state, the political counterpart of the virtual corporation.
The ascent of the trading state preceded that of the virtual state. After World War II, led by Japan and Germany, the most advanced nations shifted their efforts from controlling territory to augmenting their share of world trade. In that period, goods were more mobile than capital or labor, and selling abroad became the name of the game. As capital has become increasingly mobile, advanced nations have come to recognize that exporting is no longer the only means to economic growth; one can instead produce goods overseas for the foreign market.
As more production by domestic industries takes place abroad and land becomes less valuable than technology, knowledge, and direct investment, the function of the state is being further redefined. The state no longer commands resources as it did in mercantilist yesteryear; it negotiates with foreign and domestic capital and labor to lure them into its own economic sphere and stimulate its growth. A nation’s economic strategy is now at least as important as its military strategy; its ambassadors have become foreign trade and investment representatives. Major foreign trade and investment deals command executive attention as political and military issues did two decades ago. The frantic two weeks in December 1994 when the White House outmaneuvered the French to secure for Raytheon Company a deal worth over $1 billion for the management of rainforests and air traffic in Brazil exemplifies the new international crisis.
Timeworn methods of augmenting national power and wealth are no longer effective. Like the headquarters of a virtual corporation, the virtual state determines overall strategy and invests in its people rather than amassing expensive production capacity. It contracts out other functions to states that specialize in or need them. Imperial Great Britain may have been the model for the nineteenth century, but Hong Kong will be the model for the 21st.
The virtual state is a country whose economy is reliant on mobile factors of production. Of course it houses virtual corporations and presides over foreign direct investment by its enterprises. But more than this, it encourages, stimulates, and to a degree even coordinates such activities. In formulating economic strategy, the virtual state recognizes that its own production does not have to take place at home; equally, it may play host to the capital and labor of other nations. Unlike imperial Germany, czarist Russia, and the United States of the Gilded Age-which aimed at nineteenth-century omnicompetence-it does not seek to combine or excel in all economic functions, from mining and agriculture to production and distribution. The virtual state specializes in modern technical and research services and derives its income not just from high-value manufacturing, but from product design, marketing, and financing. The rationale for its economy is efficiency attained through productive downsizing. Size no longer determines economic potential. Virtual nations hold the competitive key to greater wealth in the 21st century. They will likely supersede the continent-sized and self-sufficient units that prevailed in the past. Productive specialization will dominate internationally just as the reduced instruction set, or “RISC,” computer chip has outmoded its more versatile but slower predecessors.
The Trading State
In the past, states were obsessed with land. The international system with its intermittent wars was founded on the assumption that land was the major factor in both production and power. States could improve their position by building empires or invading other nations to seize territory. To acquire land was a boon: a conquered province contained peasants and grain supplies, and its inhabitants rendered tribute to the new sovereign. Before the age of nationalism, a captured principality willingly obeyed its new ruler. Hence the Hapsburg monarchy, Spain, France, and Russia could become major powers through territorial expansion in Europe between the sixteenth and nineteenth centuries.
With the Industrial Revolution, however, capital and labor assumed new importance. Unlike land, they were mobile ingredients of productive strength. Great Britain innovated in discovering sophisticated uses for the new factors. Natural resources-especially coal, iron, and, later, oil-were still economically vital. Agricultural and mineral resources were critical to the development of the United States and other fledgling industrial nations like Australia, Canada, South Africa, and New Zealand in the nineteenth century. Not until late in the twentieth century did mobile factors of production become paramount.
By that time, land had declined in relative value and become harder for nations to hold. Colonial revolutions in the Third World since World War II have shown that nationalist mobilization of the population in developing societies impedes an imperialist or invader trying to extract resources. A nation may expend the effort to occupy new territory without gaining proportionate economic benefits.
In time, nationalist resistance and the shift in the basis of production should have an impact on the frequency of war. Land, which is fixed, can be physically captured, but labor, capital, and information are mobile and cannot be definitively seized; after an attack, these resources can slip away like quicksilver. Saddam Hussein ransacked the computers in downtown Kuwait City in August 1990 only to find that the cash in bank accounts had already been electronically transferred. Even though it had abandoned its territory, the Kuwaiti government could continue to spend billions of dollars to resist Hussein’s conquest.
Today, for the wealthiest industrial countries such as Germany, the United States, and Japan, investment in land no longer pays the same dividends. Since mid-century, commodity prices have fallen nearly 40 percent relative to prices of manufactured goods. The returns from the manufacturing trade greatly exceed those from agricultural exports. As a result, the terms of trade for many developing nations have been deteriorating, and in recent years the rise in prices of international services has outpaced that for manufactured products. Land prices have been steeply discounted.
Amid this decline, the 1970s and 1980s brought a new political prototype: the trading state. Rather than territorial expansion, the trading state held trade to be its fundamental purpose. This shift in national strategy was driven by the declining value of fixed productive assets. Smaller states-those for which, initially at any rate, a military-territorial strategy was not feasible-also adopted trade-oriented strategies. Along with small European and East Asian states, Japan and West Germany moved strongly in a trading direction after World War II.
Countries tend to imitate those that are most powerful. Many states followed in the wake of Great Britain in the nineteenth century; in recent decades, numerous states seeking to improve their lot in the world have emulated Japan. Under Mikhail Gorbachev in the 1980s, even the Soviet Union sought to move away from its emphasis on military spending and territorial expansion.
In recent years, however, a further stimulus has hastened this change. Faced with enhanced international competition in the late 1980s and early 1990s, corporations have opted for pervasive downsizing. They have trimmed the ratio of production workers to output, saving on costs. In some cases productivity increases resulted from pruning of the work force; in others output increased. These improvements have been highly effective; according to economist Stephen Roach in a 1994 paper published by the investment banking firm Morgan Stanley, they have nearly closed the widely noted productivity gap between services and manufacturing. The gap that remains is most likely due to measurement problems. The most efficient corporations are those that can maintain or increase output with a steady or declining amount of labor. Such corporations grew on a worldwide basis.
Meanwhile, corporations in Silicon Valley recognized that cost-cutting, productivity, and competitiveness could be enhanced still further by using the production lines of another company. The typical American plant at the time, such as Ford Motor Company’s Willow Run factory in Michigan, was fully integrated, with headquarters, design offices, production workers, and factories located on substantial tracts of land. This comprehensive structure was expensive to maintain and operate, hence a firm that could employ someone else’s production line could cut costs dramatically. Land and machines did not have to be bought, labor did not have to be hired, medical benefits did not have to be provided. These advantages could result from what are called economies of scope, with a firm turning out different products on the same production line or quality circle. Or they might be the result of small, specialized firms’ ability to perform exacting operations, such as the surface mounting of miniaturized components directly on circuit boards without the need for soldering or conventional wiring. In either case, the original equipment manufacturer would contract out its production to other firms. SCL Systems, Solectron, Merix, Flextronics, Smartflex, and Sanmina turn out products for Digital Equipment, Hewlett-Packard, and IBM. In addition, AT&T, Apple, IBM, Motorola, MCI, and Corning meet part of their production needs through other suppliers. TelePad, a company that makes pen-based computers, was launched with no manufacturing capability at all. Compaq’s latest midrange computer is to be produced on another company’s production line.
Thus was born the virtual corporation, an entity with research, development, design, marketing, financing, legal, and other headquarters functions, but few or no manufacturing facilities: a company with a head but no body. It represents the ultimate achievement of corporate downsizing, and the model is spreading rapidly from firm to firm. It is not surprising that the virtual corporation should catch on. “Concept” or “head” corporations can design new products for a range of different production facilities. Strategic alliances between firms, which increase specialization, are also very profitable. According to the October 2, 1995, Financial Times, firms that actively pursue strategic alliances are 50 percent more profitable than those that do not.
Toward the Virtual State
In a setting where the economic functions of the trading state have displaced the territorial functions of the expansionist nation, the newly pruned corporation has led to the emerging phenomenon of the virtual state. Downsizing has become an index of corporate efficiency and productivity gains. Now the national economy is also being downsized. Among the most efficient economies are those that possess limited production capacity. The archetype is Hong Kong, whose production facilities are now largely situated in southern China. This arrangement may change after 1997 with Hong Kong’s reversion to the mainland, but it may not. It is just as probable that Hong Kong will continue to govern parts of the mainland economically as it is that Beijing will dictate to Hong Kong politically. The one country-two systems formula will likely prevail. In this context, it is important to remember that Britain governed Hong Kong politically and legally for 150 years, but it did not dictate its economics. Nor did this arrangement prevent Hong Kong Chinese from extending economic and quasi-political controls to areas outside their country.
The model of the virtual state suggests that political as well as economic strategy push toward a downsizing and relocation of production capabilities. The trend can be observed in Singapore as well. The successors of Lee Kuan Yew keep the country on a tight political rein but still depend economically on the inflow of foreign factors of production. Singapore’s investment in China, Malaysia, and elsewhere is within others’ jurisdictions. The virtual state is in this sense a negotiating entity. It depends as much or more on economic access abroad as it does on economic control at home. Despite its past reliance on domestic production, Korea no longer manufactures everything at home, and Japanese production (given the high yen) is now increasingly lodged abroad. In Europe, Switzerland is the leading virtual nation; as much as 98 percent of Nestle’s production capacity, for instance, is located abroad. Holland now produces most of its goods outside its borders. England is also moving in tandem with the worldwide trend; according to the Belgian economic historian Paul Bairoch in 1994, Britain’s foreign direct investment abroad was almost as large as America’s. A remarkable 20 percent of the production of U.S. corporations now takes place outside the United States.
A reflection of how far these tendencies have gone is the growing portion of GDP consisting of high-value-added services, such as concept, design, consulting, and financial services. Services already constitute 70 percent of American GDP. Of the total, 63 percent are in the highvalue category. Of course manufacturing matters, but it matters much less than it once did. As a proportion of foreign direct investment, service exports have grown strikingly in most highly industrialized economies. According to a 1994 World Bank report, Liberalizing International Transactions in Services, “The reorientation of [foreign direct investment] towards the services sector has occurred in almost all developed market economies, the principal exporters of services capital: in the most important among them, the share of the services sector is around 40 percent of the stock of outward FDI, and that share is rising.”
Manufacturing, for these nations, will continue to decline in importance. If services productivity increases as much as it has in recent years, it will greatly strengthen U.S. competitiveness abroad. But it can no longer be assumed that services face no international competition. Efficient high-value services will be as important to a nation as the manufacturing of automobiles and electrical equipment once were. Since 1959, services prices have increased more than three times as rapidly as industrial prices. This means that many nations will be able to prosper without major manufacturing capabilities.
Australia is an interesting example. Still reliant on the production of sheep and raw materials (both related to land), Australia has little or no industrial sector. Its largest export to the United States is meat for hamburgers. On the other hand, its service industries of media, finance, and telecommunications-represented most notably by the media magnate Rupert Murdoch-are the envy of the world. Canada represents a similar amalgam of raw materials and powerful service industries in newspapers, broadcast media, and telecommunications.
As a result of these trends, the world may increasingly become divided into “head” and “body” nations, or nations representing some combination of those two functions. While Australia and Canada stress the headquarters or head functions, China will be the 21st-century model of a body nation. Although China does not innately or immediately know what to produce for the world market, it has found success in joint ventures with foreign corporations. China will be an attractive place to produce manufactured goods, but only because sophisticated enterprises from other countries design, market, and finance the products China makes. At present China cannot chart its own industrial future.
Neither can Russia. Focusing on the products of land, the Russians are still prisoners of territorial fetishism. Their commercial laws do not yet permit the delicate and sophisticated arrangements that ensure that “body” manufacturers deliver quality goods for their foreign “head.” Russia’s transportation network is also primitive. These, however, are temporary obstacles. In time Russia, with China and India, will serve as an important locus of the world’s production plant.
The Vestiges of Serfdom
The world Is embarked on a progressive emancipation from land as a determinant of production and power. For the Third World, the past unchangeable strictures of comparative advantage can be overcome through the acquisition of a highly trained labor force. Africa and Latin America may not have to rely on the exporting of raw materials or agricultural products; through education, they can capitalize on an educated labor force, as India has in Bangalore and Ireland in Dublin. Investing in human capital can substitute for trying to foresee the vagaries of the commodities markets and avoid the constant threat of overproduction. Meanwhile, land continues to decline in value. Recent studies of 180 countries show that as population density rises, per capita GDP falls. In a new study, economist Deepak Lal notes that investment as well as growth is inversely related to land holdings.
These findings are a dramatic reversal of past theories of power in international politics. In the 1930s the standard international relations textbook would have ranked the great powers in terms of key natural resources: oil, iron ore, coal, bauxite, copper, tungsten, and manganese. Analysts presumed that the state with the largest stock of raw materials and goods derived from land would prevail. CIA estimates during the Cold War were based on such conclusions. It turns out, however, that the most prosperous countries often have a negligible endowment of natural resources. For instance, Japan has shut down its coal industry and has no iron ore, bauxite, or oil. Except for most of its rice, it imports much of its food. Japan is richly endowed with human capital, however, and that makes all the difference.
The implications for the United States are equally striking. As capital, labor, and knowledge become more important than land in charting economic success, America can influence and possibly even reshape its pattern of comparative advantage. The “new trade theory,” articulated clearly by the economist Paul Krugman, focuses on path dependence, the so-called QWERTY effect of past choices. The QWERTY keyboard was not the arrangement of letter-coded keys that produced the fastest typing, except perhaps for left-handers. But, as the VHS videotape format became the standard for video recording even though other formats were technically better, the QWERTY keyboard became the standard for the typewriter (and computer) industry, and everyone else had to adapt to it. Nations that invested from the start in production facilities for the 16-kilobyte computer memory chip also had great advantages down the line in 4- and 16-megabyte chips. Intervention at an early point in the chain of development can influence results later on, which suggests that the United States and other nations can and should deliberately alter their pattern of comparative advantage and choose their economic activity.
American college and graduate education, for example, has supported the decisive U.S. role in the international services industry in research and development, consulting, design, packaging, financing, and the marketing of new products. Mergers and acquisitions are American subspecialties that draw on the skills of financial analysts and attorneys. The American failure, rather, has been in the first 12 years of education. Unlike that of Germany and Japan (or even Taiwan, Korea, and Singapore), American elementary and secondary education falls well below the world standard.
Economics teaches that products should be valued according to their economic importance. For a long period, education was undervalued, socially and economically speaking, despite productivity studies by Edward Denison and others that showed its long-term importance to U.S. growth and innovation. Recent studies have underscored this importance. According to the World Bank, 64 percent of the world’s wealth consists of human capital. But the social and economic valuation of kindergarten through 12th-grade education has still not appreciably increased. Educators, psychologists, and school boards debate how education should be structured, but Americans do not invest more money in it. Corporations have sought to upgrade the standards of teaching and learning in their regions, but localities and states have lagged behind, as has the federal government. Elementary and high school teachers should be rewarded as patient creators of high-value capital in the United States and elsewhere. In Switzerland, elementary school teachers are paid around $70,000 per year, about the salary of a starting lawyer at a New York firm. In international economic competition, human capital has turned out to be at least as important as other varieties of capital. In spite of their reduced functions, states liberated from the confines of their geography have been able, with appropriate education, to transform their industrial and economic futures.
The Reduced Danger of Conflict
As nations turn to the cultivation of human capital, what will a world of virtual states be like? Production for one company or country can now take place in many parts of the world. In the process of downsizing, corporations and nation-states will have to get used to reliance on others. Virtual corporations need other corporations’ production facilities. Virtual nations need other states’ production capabilities. As a result, economic relations between states will come to resemble nerves connecting heads in one place to bodies somewhere else. Naturally, producer nations will be working quickly to become the brains behind emerging industries elsewhere. But in time, few nations will have within their borders all the components of a technically advanced economic existence.
To sever the connections between states would undermine the organic unit. States joined in this way are therefore less likely to engage in conflict. In the past, international norms underlying the balance of power, the Concert of Europe, or even rule by the British Raj helped specify appropriate courses of action for parties in dispute. The international economy also rested partially on normative agreement. Free trade, open domestic economies, and, more recently, freedom of movement for capital were normative notions. In addition to specifying conditions for borrowing, the International Monetary Fund is a norm-setting agency that inculcates market economics in nations not fully ready to accept their international obligations.
Like national commercial strategies, these norms have been largely abstracted from the practices of successful nations. In the nineteenth century many countries emulated Great Britain and its precepts. In the British pantheon of virtues, free trade was a norm that could be extended to other nations without self-defeat. Success for one nation did not undermine the prospects for others. But the acquisition of empire did cause congestion for other nations on the paths to industrialization and growth. Once imperial Britain had taken the lion’s share, there was little left for others. The inability of all nations to live up to the norms Britain established fomented conflict between them.
In a similar vein, Japan’s current trading strategy could be emulated by many other countries. Its pacific principles and dependence on world markets and raw materials supplies have engendered greater economic cooperation among other countries. At the same time, Japan’s insistence on maintaining a quasi-closed domestic economy and a foreign trade surplus cannot be successfully imitated by everyone; if some achieve the desired result, others necessarily will not. In this respect, Japan’s recent practices and norms stand athwart progress and emulation by other nations.
President Clinton rightly argues that the newly capitalist developmental states, such as Korea and Taiwan, have simply modeled themselves on restrictionist Japan. If this precedent were extended to China, the results would endanger the long-term stability of the world economic and financial system. Accordingly, new norms calling for greater openness in trade, finance, and the movement of factors of production will be necessary to stabilize the international system. Appropriate norms reinforce economic incentives to reduce conflict between differentiated international units.
Defusing the Population Bomb
So long as the international system of nation-states lasts, there will be conflict among its members. States see events from different perspectives, and competition and struggle between them are endemic. The question is how far conflicts will proceed. Within a domestic system, conflicts between individuals need not escalate to the use of physical force. Law and settlement procedures usually reduce outbreaks of hostility. In international relations, however, no sovereign, regnant authority can discipline feuding states. International law sets a standard, but it is not always obeyed. The great powers constitute the executive committee of nation-states and can intervene from time to time to set things right. But, as Bosnia shows, they often do not, and they virtually never intervene in the absence of shared norms and ideologies.
In these circumstances, the economic substructure of international relations becomes exceedingly important. That structure can either impel or retard conflicts between nation-states. When land is the major factor of production, the temptation to strike another nation is great. When the key elements of production are less tangible, the situation changes. The taking of real estate does not result in the acquisition of knowledge, and aggressors cannot seize the needed capital. Workers may flee from an invader. Wars of aggression and wars of punishment are losing their impact and justification.
Eventually, however, contend critics such as Paul Ehrlich, author of The Population Bomb, land will become important once again. Oil supplies will be depleted; the quantity of fertile land will decline; water will run dry. Population will rise relative to the supply of natural resources and food. This process, it is claimed, could return the world to the eighteenth and nineteenth centuries, with clashes over territory once again the engine of conflict. The natural resources on which the world currently relies may one day run out, but, as before, there will be substitutes. One sometimes forgets that in the 1840s whale oil, which was the most common fuel for lighting, became unavailable. The harnessing of global energy and the production of food does not depend on particular bits of fluid, soil, or rock. The question, rather, is how to release the energy contained in abundant matter.
But suppose the productive value of land does rise. Whether that rise would augur a return to territorial competition would depend on whether the value of land rises relative to financial capital, human capital, and information. Given the rapid technological development of recent years, the primacy of the latter seems more likely. Few perturbing trends have altered the historical tendency toward the growing intangibility of value in social and economic terms. In the 21st century it seems scarcely possible that this process would suddenly reverse itself, and land would yield a better return than knowledge.
Diminishing their command of real estate and productive assets, nations are downsizing, in functional if not in geographic terms. Small nations have attained peak efficiency and competitiveness, and even large nations have begun to think small. If durable access to assets elsewhere can be assured, the need to physically possess them diminishes. Norms are potent reinforcements of such arrangements. Free movement of capital and goods, substantial international and domestic investment, and high levels of technical education have been the recipe for success in the industrial world of the late twentieth century. Those who depended on others did better than those who depended only on themselves. Can the result be different in the future? Virtual states, corporate alliances, and essential trading relationships augur peaceful times. They may not solve domestic problems, but the economic bonds that link virtual and other nations will help ease security concerns.
The Civic Crisis
Though peaceful in its international implications, the rise of the virtual state portends a crisis for democratic politics. Western democracies have traditionally believed that political reform, extension of suffrage, and economic restructuring could solve their problems. In the 21st century none of these measures can fully succeed. Domestic political change does not suffice because it has insufficient jurisdiction to deal with global problems. The people in a particular state cannot determine international outcomes by holding an election. Economic restructuring in one state does not necessarily affect others. And the political state is growing smaller, not larger.
If ethnic movements are victorious in Canada, Mexico, and elsewhere, they will divide the state into smaller entities. Even the powers of existing states are becoming circumscribed. In the United States, if Congress has its way, the federal government will lose authority. In response to such changes, the market fills the vacuum, gaining power.
As states downsize, malaise among working people is bound to spread. Employment may fluctuate and generally decline. President Clinton observed last year that the American public has fallen into a funk. The economy may temporarily be prosperous, but there is no guarantee that favorable conditions will last. The flow of international factors of production-technology, capital, and labor-will swamp the stock of economic power at home. The state will become just one of many players in the international marketplace and will have to negotiate directly with foreign factors of production to solve domestic economic problems. Countries must induce foreign capital to enter their domain. To keep such investment, national economic authorities will need to maintain low inflation, rising productivity, a strong currency, and a flexible and trained labor force. These demands will sometimes conflict with domestic interests that want more government spending, larger budget deficits, and more benefits. That conflict will result in continued domestic insecurity over jobs, welfare, and medical care. Unlike the remedies applied in the insulated and partly closed economies of the past, purely domestic policies can no longer solve these problems.
The Necessity of Internationalization
The state can compensate for its deficient jurisdiction by seeking to influence economic factors abroad. The domestic state therefore must not only become a negotiating state but must also be internationalized. This is a lesson already learned in Europe, and well on the way to codification in East Asia. Among the world’s major economies and polities, only the United States remains, despite its potent economic sector, essentially introverted politically and culturally. Compared with their counterparts in other nations, citizens born in the United States know fewer foreign languages, understand less about foreign cultures, and live abroad reluctantly, if at all. In recent years, many English industrial workers who could not find jobs migrated to Germany, learning the language to work there. They had few American imitators.
The virtual state is an agile entity operating in twin jurisdictions: abroad and at home. It is as prepared to mine gains overseas as in the domestic economy. But in large countries, internationalization operates differentially. Political and economic decision-makers have begun to recast their horizons, but middle managers and workers lag behind. They expect too much and give and learn too little. That is why the dawn of the virtual state must also be the sunrise of international education and training. The virtual state cannot satisfy all its citizens. The possibility of commanding economic power in the sense of effective state control has greatly declined. Displaced workers and business people must be willing to look abroad for opportunities. In the United States, they can do this only if American education prepares the way.