Change We Can’t Believe In

For those still confused: No, Kim Jong Un is probably not a reformist after all.

At an early April meeting of the Supreme People's Assembly, North Korea's version of a legislature, the leadership promoted Pak Pong Ju to the position of premier, once again stirring speculation that it is pondering much-needed economic reforms. Some pundits have speculated that Pak is the Korean face of reform; he was indeed premier during a period of modest economic policy changes in the early 2000s, before reform went into reverse and he was purged. And just like before, Pak heads the cabinet, the political body with the most immediate interest in economic policy.

But Pak's appointment raises a series of questions. Can a country issuing nuclear threats and aggressively pursuing a missile program hang out a shingle that says "open for business"? Can North Korea suspend access to Kaesong, an industrial park run jointly with South Korea, and still claim to seek foreign investment? Will either domestic or foreign firms find any new policy measures Pak might institute credible? For the answer to any of these questions to be yes, the world will be looking for deeds, not just speculation.

The domestic political challenges to reform are the most fundamental issue, and unfortunately the least understood by outsiders. North Korea remains desperately poor; its per capita income is roughly on par with Pakistan's or the Ivory Coast's. The World Food Program estimates that nearly a third of the country is vulnerable to malnutrition. There is a lot of work to do. To succeed, new economic policy measures must ultimately reallocate resources from the bloated military sector to more productive forms of investment, and increase household consumption.

This is no easy task, in part because the military is deeply intertwined with the party and state as a result of Kim Jong Il's "military first" policy. Kim Jong Un and his backers have purged high-ranking military officers. But since succeeding his father in December 2011, the younger Kim has also promoted hundreds of officers, and brought dozens into the Politburo, Party Secretariat, National Defense Commission, and other key institutions. It's unlikely Kim will be able to convince the military to launch reforms that weaken its influence. The military and security apparatus not only influence important policy decisions, but also run businesses that enrich high-ranking officers and their networks. In late March, Kim was shown visiting a military unit that made playground equipment and musical instruments. Are these units going to give up their businesses and operate in a more competitive environment?

For North Korea, the central economic questions center on the relationship between the government, state-owned enterprises, and the private sector. Reform means giving managers more discretion and allowing greater freedom for private actors to invest, hire, and make money. Is the regime OK with an emergent capitalist class? The Chinese lived with it, and if the reforms extend only to their cronies, the regime may be adequately comfortable. Half-baked reforms are better than nothing. But they are also difficult to fix later, as both Russia and China are now learning.

History suggests that North Korean leaders have little tolerance for unleashing market forces. The regime ultimately backpedaled from its 2002 reforms: It opened markets, only to harass and close them when it became uncomfortable with the emergence of potentially powerful private traders. In 2009, in the mother of all policy mistakes, the regime undertook a massive forced currency conversion that wiped out the working capital of major traders (or at least those without inside information). With markets closed, the country experienced hyperinflation as traders and households fled the domestic currency and hoarded commodities.

Surveys Marcus Noland of the Peterson Institute of International Economics and I conducted on Chinese firms doing business in North Korea reveal a pattern that almost certainly also pertains to the domestic market. Two types of Chinese firms succeed in North Korea: those that are large and protected by political connections, and those that are small and can fly under the radar. While this combination is better than having only a sclerotic public sector, the scope for growth is limited at the outset.

In the meetings in early April, the North Korean leadership outlined a new  strategic course: seek to develop nuclear weapons and space technology -- a euphemism for a long-range missile program -- while at the same time focusing on economic reconstruction. But North Korea has a small economy and reforms are unlikely to succeed unless they attract foreign capital, technology, and management.

Who has the nerve to wade into such a setting? The country is now under a complex sanctions regime. The new financial sanctions are only supposed to apply to transactions related to the country's weapons of mass destruction and missile programs. But in an economy where everything is ultimately under government control, it is hard to draw such fine lines and many firms won't risk investing at all.

Potential investors will note that the recent cycle of escalatory rhetoric began in February, while the U.N. Security Council was negotiating a new sanctions resolution. These sanctions will likely be more effective than previous rounds, and the Chinese appear to be putting some restraints on North Korean banks. No matter how well-intentioned North Korean policy statements of economic openness may appear, they are easily reversible. North Korea is -- unsurprisingly -- a difficult place for foreign companies to do business. Even Chinese firms have been embroiled in debilitating investment disputes.

A crucial signal with respect to North Korean intent -- and the likely foreign response -- is the Kaesong Industrial Complex; consider it a leading indicator of North Korean credibility. On Monday Pyongyang said it will recall more than 50,000 workers from Kaesong, and consider closing it permanently. The largest export-processing zone in the country -- raking in about $90 million a year for North Korea--has been turned into a political football. Shutting it down would be a major annoyance for the more than 120 South Korean firms, reliant on cheap labor, that operate there. But for North Korea, the consequences will be much worse. This may explain the regime's caution.

Why should foreign firms bother when so many other locations are welcoming and supportive of foreign investors? Only a few types of firms appear willing to risk it. North Korea's reserves of natural resources are attractive,  and large Chinese firms have signed contracts that are effectively guaranteed by the flow of commodities. A second group of firms are those from countries that are unlikely to take a particularly close look at U.N. sanctions resolutions and lack the complex export and financial control mechanisms (for example, the Egyptian telecommunications firm Orascom, which helped build North Korea's cellular network). Smaller, labor-intensive Chinese firms appear to be doing business, and some South Korean firms have invested in Kaesong, where they are effectively protected by insurance and a kind of mutual hostage game in which both sides are willing to leave the zone open.

But this excludes Japan, Russia, Western Europe, the United States, most South Korean firms, and a large swath of potential investment from other middle-income countries in the region such as Malaysia, Taiwan, or Thailand. The cast of residual characters raises other risks for the North Korean leadership, most notably whether it wants to be an economic colony of China.

In Shakespeare's play Henry IV Part I, a prince claims that he can summon spirits from the "vasty deep," to which a soldier retorts "Why, so can I, or so can any man; but will they come when you do call for them?" Put another way, economic reform and growth are not a function of hortatory statements and proclamations of grandiose intent. Reforms should ultimately elicit investment and effort. There is no evidence of a stampede to North Korea's door.

North Korea does not need to become laissez-faire Hong Kong in order to prosper; it can undertake reforms with its own characteristics, as China did. Indeed, given how distorted the economy is, even modest reforms will yield gains. My fingers remain firmly crossed. But the regime does not seem to appreciate the contradiction in maintaining a huge, threatening military presence while at the same time seeking to assure market actors that the water is fine and they should dive in.

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Head of the Class

Don't look now, declinists, but the U.S. economy is strong and poised to beat its rivals. Yes, even China.

After World War II, when fear of Hitler was giving way to fear of Stalin, George Orwell rebuked intellectuals for "the instinct to bow down before the conqueror of the moment, to accept the existing trend as irreversible." In recent decades, the chattering classes have continued to show the same reflex, bowing down before the rise of Japan in the 1980s, Silicon Valley in the 1990s, and the broad rise of the big emerging markets -- known as the BRICS -- in recent years. After a decade in which the U.S. share of the global economy declined from 32 to 22 percent, while the emerging market's share rose from 20 to 35 percent, many intellectuals assumed emerging countries led by Brazil, Russia, India, and China were to be the conquerors of the future.

Not so fast. In fact, the hot trend of the 2000s is fading fast this decade, and the BRICS are all falling back to Earth. Only China is growing faster than the emerging-market average, and even there the annual GDP growth rate dropped from the 11 percent pace of the past decade to below 8 percent last year -- and will possibly slow to 5 to 6 percent in the next few years, weighed down by the sheer size and age of China's increasingly middle-income economy. India has slowed just as dramatically, Russia and Brazil even more so, and it is now possible the latter two will grow slower than the United States in coming years -- a shocking comedown given that their per capita incomes are much lower. Those who forecast the inevitable rise of the BRICS and decline of the West may have to pick new conquerors.

The world economy is returning to its normal pattern, which produces an ever-changing roster of few winners and many losers. In the developing world, the slowdown in the BRICS has been accompanied by the emergence of new stars, from the Philippines to Nigeria to Turkey. In the developed world, by most key measures of recovery, France, Italy, and Japan are doing quite poorly, whereas Germany and some Nordic countries seem to be faring better. But despite the recent uptick in unemployment, the United States is the leading "breakout nation" -- the one most likely to beat the growth rate of rivals in its income class, as well as expectations for that class, over the next five years.

The markets tend to register these changes faster than pundits do. Over the past year, the U.S. economy grew at about the same pace as the global average for the first time since 2003, halting the decline in its share of the world economy. In fact, the United States was the only Western country to stop its losing streak -- and it came as such an unexpected surprise to investors that they have driven U.S. stock prices to all-time highs. Meanwhile, the BRICS economies are not living up to the hype, so on average their stock markets, in dollar terms, are trading 40 percent below their historical peaks.

It's no secret that the United States is younger and more flexible than other rich economies, but it is not well understood that these advantages are now propelling a broad advance in America's competitive position -- an advance that could largely erase many of its worst fears, over mounting debt, high gas prices, the falling dollar, and a shrinking manufacturing industry.

Here's how the United States really stacks up against the competition, in these critical areas. The United States is winning the race to dig its way out of debt, a process called "deleveraging." While total U.S. debt (combining government, corporate, and household debt) is now strikingly high, at 340 percent of GDP, what matters most for growth is the pace and direction of change. The McKinsey Global Institute has shown that the United States is the only major developed economy that since 2008 has lowered its total debt as a share of GDP, while that burden is rising in the leading European economies. One reason is that the U.S. system allows banks to force delinquent mortgage holders into foreclosure, from which Europeans are still heavily protected. This is brutal but effective because an economy is hard-pressed to recover when its debt pile is growing. China, with a total debt burden that has hit 200 percent of GDP and is still rising fast, arguably faces a bigger challenge than the United States, in part because it's much less wealthy.

The falling value of the dollar over the past decade is another important sign of American competitive flexibility that has been widely misinterpreted as a symbol of weakness. The dollar is now around 25 percent below its peak in inflation-adjusted terms against its trading partners, which makes U.S. exports more affordable abroad. The U.S. share of global exports is currently up a full point from its all-time low of 7.5 percent, hit in 2008. More importantly, for all the talk about the dollar's demise, its international status has not slipped in decades, with the dollar share of global foreign exchange reserves holding steady at more than 60 percent. Neither the euro nor the Chinese yuan poses a serious challenge to the dollar as the world's preferred currency.

The competitive exchange rate also fuels the renaissance of manufacturing in the United States, which reacted much more quickly than Europe or Japan to new competition from the emerging world. In the 2000s, U.S. manufacturers cut back wages, replaced expensive American suppliers with foreign ones, and cut 30 percent of factory jobs, while European manufacturers cut just 17 percent. These moves were tough, but the result was that China's share of manufactured exports rose almost entirely at Europe's expense, while the United States held steady. By 2011, U.S. manufacturers had put themselves in position to make a comeback as employers, creating around 200,000 jobs in each of the last two years, the best showing since the 1990s. Meanwhile, Europe and Japan, which resisted adapting to a more globalized world, continued to lose manufacturing jobs or saw no change.

The U.S. energy revolution is also helping manufacturing stage a comeback, boosted in particular by the increasing production of oil and natural gas from previously unreachable reserves trapped in shale rock. This has driven down U.S. natural gas prices to one of the world's lowest rates, which helps explain why domestic manufacturers are now moving plants back home. Often, America's economic rivals lack the large supplies of water required for blasting gas out of shale rock or the clear land-use laws and ready financing that make the revolution possible in the United States. As a result, the United States now has a huge lead in fracking technology, with 425 gas rigs drilling in operation versus about 30 in Europe. The United States also has a significant lead over the BRICS countries in developing the expertise and infrastructure for this energy boom.

The question after a global economic crisis is always the same: What is the next growth driver? At a recent conference, entrepreneur Peter Thiel argued that the answer is usually a major advance in technology, which is most likely to emerge in a country like the United States that promotes innovation. The United States still accounts for one-third of global R&D spending, which is why it is leading critical advances in digital technology, such as cloud computing. As factories come to rely more heavily on digital technology than on cheap labor, the edge in manufacturing shifts from developing countries like China back to developed countries like the United States. And as China and other BRICS grow richer, their citizens will demand the kind of kind of custom-designed products made in the most advanced factories, which are emerging first in the United States and the West.

In a global economy now defined by competing forms of capitalism, the American brand appears to be winning. The biggest risk by far is government debt because the U.S. government lags well behind its households and companies in beginning the painful deleveraging process. In coming years, the U.S. government debt burden is likely to slow GDP growth by about a point, to around 2.5 percent, compared with the historical average -- but that will still be fast enough to lead the rich world. It won't be the only success story in the West: Germany has much less of a debt problem than France, Spain is moving much faster to pare down labor costs than Italy, and so on. It's a tough age, but also very fair in the sense that there is no global tailwind for any country, rich or poor. The winners will take their mantra from a Latin proverb: "If there is no wind, row."

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