The Beginning of the End

The U.S. combat presence in Iraq is over, and it is likely all troops will be gone by the end of next year. But strong support will still be needed in the weeks and months to come, lest the country slip back into chaos and conflict.

On Thursday, the last U.S. combat brigade to leave Iraq crossed into Kuwait, fulfilling President Barack Obama's pledge to withdraw all but 50,000 American troops from a country with which the United States has become intimately, and painfully, familiar over the last seven and a half years.

The remaining soldiers and marines will stay in Iraq until Dec. 31, 2011, for training and other support purposes. Although the possibility cannot be ruled out, it seems quite unlikely that their presence will be extended beyond the 2011 deadline. Political imperatives in both Iraq and the United States seem to work against this possibility, even though there are those in both countries who argue that a longer-term U.S. residual force is needed.

Having landed in Baghdad as U.S. ambassador to Iraq at the end of June 2004, I find it a truly remarkable and positive accomplishment that we are able to look to the day not too far off when Iraqi security forces will be able to assume full and complete responsibility for their country's security. At the time of my arrival, Iraqi security forces were, for all practical purposes, nonexistent. There was, for example, only one -- yes, one -- Iraqi army battalion and it was composed of various ethnic and sectarian elements. Today, there are some 600,000 Iraqi security forces and important strides have been made toward giving Iraq's security organizations a national rather than partisan character. This is no small achievement; it has taken seven years to accomplish and only after some false starts and perilous moments.

In the wake of the Samarra Mosque bombing in 2006 and the ensuing sectarian strife, those of us concerned with Iraq could not have imagined the dramatic reversal of fortunes that would occur in the ensuing two years -- the death of al Qaeda in Iraq leader Abu Musab al-Zarqawi, the liberation of Basra by the Iraqi army, and the extension of the government's authority to the country as a whole. By 2008, these improvements had given the government of Iraq the necessary self-assurance to negotiate the withdrawal arrangements that are now being implemented.

But can Iraq really remain stable once U.S. troops have completely withdrawn? While there are no guarantees, the prospects for Iraq's security and stability beyond 2011 look as good or better than they have at any time in the recent past. The Iraqi army now has close to 200 trained combat battalions, a formidable increase from the somber days when I arrived in 2004, and they are spread throughout the country. The specter of sectarianism poisoning the ranks of Iraqi military and police forces remains the single most serious threat to be guarded against. But progress since the 2007 surge in nurturing the army and police as truly national institutions has been encouraging. Vigilance and political maturity will be needed to ensure that this positive trend continues.

If our military role in Iraq ends soon, as it most likely will, then what will be the glue that holds our two countries' relationship together? For one thing, the United States intends to maintain a robust civilian diplomatic and developmental presence in Iraq for the foreseeable future -- so as not to jeopardize the hard fought gains of the last seven years. The sending of senior diplomat James Jeffrey to Baghdad is a signal of continued high-level interest and concern for the stability and well-being of Iraq. But this signal needs to be reinforced by congressional support for the funding requests that have been submitted for programs in areas such as technical assistance, rule of law, poverty reduction, women's issues, and economic development. And we need to continue efforts to encourage U.S. private-sector involvement in Iraq's economy. Last, but certainly not least, our reduced military profile will place an even higher premium on proactive regional diplomacy. While the focus of U.S. military efforts abroad has now shifted irrevocably toward Afghanistan, falling short of our diplomatic and funding commitments to Iraq risks allowing the country to slip back into conflict and chaos.

But can the steadying influence of U.S. diplomacy on the Iraqi political process can be maintained as our military presence diminishes? It's hard to say, but it was inevitable that sooner or later this aspect of our relationship also had to be normalized. Just as in the transition from occupation to full sovereignty Iraq is assuming responsibility for its security, so too must it take complete ownership of its own political arrangements. The achievement of a parliamentary democracy in Iraq so soon after the demise of a long-entrenched dictatorial regime is a remarkable accomplishment. That's not to say that the current situation, with the recent spike in suicide bombings and a continued stalemate in forming a government since the March elections is ideal, but there has been real progress. A continued U.S. civilian presence will be a strong encouragement to that process, but the days of backroom political deals brokered by the U.S. Embassy in Baghdad will be fewer and farther between.

That doesn't mean the United States won't remain critical to Iraq's future. Too often in the past we have tired of an international undertaking when our military role has finished and "our boys have come home." We should not underestimate the effect that a continued demonstration of interest and concern can have on Iraq's future. It is important that not only Iraq but the region as a whole understand that this long-suffering country continues to enjoy strong American support. A properly endowed U.S. government civilian presence in Iraq can help preserve the gains of the past seven years and help avoid a repeat of the instabilities of the past.



Is China Turning Japanese?

China is now the world's second largest economy. Here's why Beijing, not Washington, should be worried.

China has formally overtaken Japan as the world's second largest economy. Yet, for all the recent excited commentary, there's less cause for baijiu toasts in Beijing than they might think. That's because China's economic growth has followed what's sometimes called "the Japanese model."  In Japan and other Asian countries, this model has proved extraordinarily successful in the short term in generating eye-popping rates of growth -- but it always eventually runs into the same fatal constraints: massive overinvestment and misallocated capital. And then a period of painful economic adjustment. In short: Beijing, beware.

Japan's "lost decade" of the 1990s -- from which it still has not emerged -- followed a period of high growth, at the heart of which were massive subsidies for manufacturing and investment. The Japanese model channels wealth away from the household sector to subsidize growth by restraining wages, undervaluing the currency, and, most powerfully, forcing down the cost of capital. In every prior case, once the train gets rolling, it has been very difficult to correct course. That's because too much of the economy depends on hidden subsidies to survive. 

Nor is Japan the only country to rise quickly and then suffer in this fashion.  Brazil, which experienced "miracle" growth years during the 1960s and 1970s, had its own lost decade in the 1980s, for similar reasons. Beijing would do well to heed these tales of caution.

From a distance, China's boom times seem unstoppable. It's worth looking closer. In early June, the head of China's official carmakers' association forecast that 2010 sales will exceed 15 million units, surpassing the United States this year as the largest market for new cars in the world. But there was bad news buried in this seemingly good number. After growing 48 percent in the first half of 2010, and 45 percent last year, this forecast suggests a 20 percent contraction in car sales in the second half of 2010.

These numbers will likely intensify the already-fierce debate over Chinese consumption growth. In order to rebalance China's economy, which still depends heavily on exports, Beijing must raise its very low consumption share of GDP. That share declined from 46 percent of GDP in 2000 to an unprecedented low of 41 percent in 2003 -- and then shrank further to an astonishing 38 percent in 2006, finally falling below 36 percent in 2009. (In August, Credit Suisse released a study by the China Reform Foundation's  Wang Xiaolu, which suggested that if we include China's unrecorded economy -- market activity that isn't reflected in official data -- the consumption share is even lower.)

Chinese policymakers aren't blind to the urgency of reversing this decline. A low consumption share is the obverse of China's excessive reliance on export surpluses and investment. Unless domestic consumption expands dramatically, China can continue growing rapidly only by increasing investment well beyond what is economically useful or by forcing larger trade surpluses onto a reluctant world.  To raise consumption, Beijing has implemented a number of policies in the past five years, and especially since 2008, aimed at boosting Chinese consumption.  But are they working?

On the positive side, automobile sales surged last year. For most analysts, this was immensely good news, signaling a major shift in the consuming behavior of Chinese households. But skeptics disagreed. They claimed that the surge in demand for automobiles was caused mainly by unsustainable government subsidies and tax rebates.  Last year also saw a surge in durable goods, but they were also backed by subsidies.

More importantly, the skeptics argued, any current increase in automobile and durable goods sales would be reversed in the future as households absorbed the cost of the subsidies. Subsidies must be paid for, ultimately by the household sector -- and as they are paid out of future income, consumption will rise today, but inevitably decline tomorrow.

It seems the skeptics may have been right. If the growth in automobile and other consumption is indeed substantially weaker in the following months, as evidence seems to suggest, it would suggest that low consumption in China is not a discrete problem that can be resolved with administrative measures. It would argue instead that the consumption problem is fundamental to China's economic growth model and therefore cannot be resolved without a substantive change to the status quo.

Most economists continue to argue nonetheless that surging retail-sales figures and rising wages show China's shift to greater consumer spending is on track and that, within ten years, consumption is likely to be anywhere from 47 to 50 percent of GDP -- but this is still too low by most measures. Even if the rest of the world were willing to run the large trade deficits needed to support China's low relative consumption for so long, the math that gets us there is tricky at best.

Here's why.

In order to get consumption to generate 47 to 50 percent of GDP in ten years, every year consumption needs to grow faster than GDP by 3 to 4 percentage points, something it has never been able to do. If China continues growing at 7 to 9 percent for the next decade, as many analysts are projecting, consumption must grow by 10 to 14 percent, much faster than it ever has in post-reform Chinese history. Yet all projections show China growing more slowly than it ever has during these next ten years.

It's arithmetically possible, of course, but there are two schools of thought about how to proceed. One school argues that relatively low-consumption growth can be reversed without changing the fundamental growth model.  Many reasons have been given for low Chinese consumption -- demographics, Confucian culture, skewed tax incentives, amateurish marketing, the sex imbalance, the tattered social safety net, etc. If Beijing takes administrative steps to address the correct cause of low consumption, so goes the theory, it will automatically rise.

If they are right, then presumably Beijing can goose consumption while keeping GDP growth rates high. But if that's all it takes, one wonders why they just haven't gotten on with it. Since 2005 the government has wanted to drive up the consumption share of GDP, and yet it has plummeted.

The other, smaller (but rapidly growing) school of thought argues the model itself prohibits high consumption: growth is high because consumption is low. China cannot enjoy the double-digit GDP growth generated by low wages, cheap capital, and an undervalued currency and still have strong domestic consumer demand.  This school has been arguing for five years that the measures Beijing has taken to boost consumption growth will fail because they do not address the underlying cause.

We will just have to wait and see who is right, but the arithmetic seems to suggest that current rates of GDP growth won't allow for the surge in consumer spending necessary for China to rebalance away from its excess reliance on exports and investment.  Unless China's GDP growth plummets to below 5 percent annually on average, and probably even then, it is very unlikely that consumption can represent 47 to 50 percent of GDP in ten years.

So why do Chinese consume such a low share of what they produce -- in spite of determined efforts by Beijing to get them to increase consumption?  Contrary to conventional thinking, the Chinese have no aversion to consuming. They are eager shoppers, as even the most cursory visit to a Chinese mall will indicate. The problem is that Chinese households own such a small share of total national income that their consumption is necessarily also a small share. And just as the household share of national income has declined dramatically in the past decade, so too has household consumption.  

This isn't to say households are getting poorer. On the contrary, they are getting richer quite rapidly, but they are getting richer more slowly than the country overall, which means their share of total income is declining.

If Beijing wants to increase the consumption share of GDP, it shouldn't waste effort and money trying to create additional incentives for consumption, tinkering with subsidies and taxes, improving the social safety net, attempting to change cultural habits. What is needed is to increase the share of national income that households take home. Give them more money, and they will spend it.

So how can their share rise? Here, the problem gets very difficult.

One option might be for Beijing to engineer a huge shift of state wealth to the household sector through, say, a massive privatization program. This could drive up consumption significantly by boosting household wealth, but the likelihood of mass privatization is slim, given the political realities in China.

Another option, and ultimately the only sustainable path forward, would involve reversing the subsidies that generated such furious growth. Wage growth must at least keep pace with productivity growth; interest rates must rise substantially; and the currency must be revalued. But if any of these happen too quickly, we could expect a surge in bankruptcies -- as old businesses struggle to survive without familiar subsidies.

Unfortunately, the longer China waits to make the transition from this model of growth, the more difficult the transition will be. Forcing banks to fund projects at artificially low interest rates inevitably raises non-performing loans, and these eventually become government debt. The longer China waits, the more debt there will be and the more dependent growth will be on the subsidies.

For a worrying case study, one need only look to Japan, which grew very rapidly thanks largely to very high rates of investment forced through the banking system.  For a long time the problem of misallocated investment -- which was whispered about in Tokyo but not taken too seriously -- didn't seem to matter.  Everyone "knew" that Japan's leaders could manage a transition easily. After all, they were extremely smart, with a deep knowledge of the very special circumstances that made Japan unique, with real control over the economy, with a strong grasp of history and penchant for long-term thinking, and most of all with a clear understanding of what was needed to fix Japan's problems. Sound familiar?

In the end, they were seduced by their own success. Look what a great job they had already done: by the early 1990s Japan had generated so much investment-driven growth that it had grown from 7 percent of global GDP in 1970 to 10 percent in 1980, and then surged to nearly 18 percent at its peak in the early 1990s. In about twenty years, Japan's share of global GDP was two-and-a-half times its initial share. And yet it kept boosting investment to generate high growth well into the early 1990s, long after the economic value of its investment had turned negative.

Less than 20years later, after a terribly long struggle to adjust to high debt and massive overinvestment, Japan is about to be overtaken by China with only 8 percent of global GDP. Japan, in other words, has given back in less than two decades almost the entire share of global GDP it had taken in the two astonishing decades that preceded it (during the same period the United States has roughly maintained its share). 

The sooner China begins the difficult transition, the less costly it will be, but in no circumstance is it likely to be easy. They key will be to get consumption to grow quickly relative to GDP, and China might simply not have the time to do it by reversing the wage, currency, and interest-rate subsidies paid by the household sector. Among other unlikely things, it will require the rest of the world continue to absorb its soaring trade surplus. In the end, the only "easy" solution (economically, not politically) might be a massive transfer of wealth from the public sector to households, perhaps via privatization. China will probably reluctantly play this card -- but only after a painful period of sluggish growth forces Beijing's hand.