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A New Kind
Amid the worldwide clamor of ethnic politics, regional conflict, and financial crisis, a new reality is emerging. Developed states are putting aside military and territorial ambitions as they struggle not for political dominance but for a greater share of world output. In the process, nations are shrinkingin function if not in geographic size. The nation-state is becoming a tighter, more vigorous unit capable of sustaining the pressures of worldwide competition. We are entering a world in which the most important resources are the least tangiblewhere land is less important than an educated populace, where stockpiles of goods, capital, and labor are less important than flows, and where parochial interests are less important than the international economy as a whole.
It is true that the ambitions of lesser states to gain territory still engage the world's attention. Serbia's Slobodan Milosevic extended ethnic cleansing to Kosovo. Several years ago Radovan Karadzic tried to create an independent Serbian province in Bosnia with allegiance to Belgrade. In 1990 Iraq's Saddam Hussein aimed to corner the world oil market through military aggression against Kuwait (also aimed at Saudi Arabia); control of oil, a product of land, represented the acme of his ambitions. India and Pakistan, both possessing nuclear capabilities, are vying for territorial dominance over a Kashmiri population that neither may be fully able to control. Ethnic rivalries beset Hutu and Tutsi in Rwanda, Albanians and Serbians in Kosovo.
These exampleslook to the past. Developing countries, which still produce goods derived from land, continue to covet territory. But where the products of land no longer determine market and power relationships, a new form of state is being born: the virtual nation, a nation based on mobile capital, labor, and information. The virtual state is a political unit that has downsized its territorially based production capability and is the logical consequence of emancipation from land. Virtual states and their associates would rather plumb the world market than acquire territory.
In its pure forman ideal model toward which many states are tendingthe virtual state carries with it the possibility of an entirely new system of world politics. In the past, when military conflict and the desire for territory determined relations between nations, the main flow between countries consisted of armies. Future flows will be largely economic as capital, technology, manpower, and information move rapidly among states. In the long term, national access to international factors of production can replace the need to control additional land.
This does not mean that states will be abolished as territorial entities, that conflicts over land will never occur, or that politics can take place without geographic space. Geographic concerns reassert themselves in Eastern Europe. States require a certain minimum of territory to conduct political business and establish representative institutions differentiated from those of other countries. As the success of Singapore has demonstrated, however, huge open spaces are scarcely necessary for economic competence, nor are preexisting competitive products. Singapore does not produce a single commodity in which it had a prior comparative advantage. It does not have oil, tin, or ricethe typical products of its neighbors. Its economic position rests on "created" comparative advantages in semiconductors, textiles, and important service industries. The countries now entering the international system are much smaller than their imperial forebears, yet they can achieve stunning economic capacity.
Transferring the bulk of their home production overseas, and shifting most of their economy to high-level services, virtual nations reshape both productive and international relationships. They inaugurate a world based on mastery of flows of production and purchasing power rather than stocks of goods. They emancipate labor from routine mechanical tasks and offer new employment in technical or creative services. They usher in a world based on education and human capital rather than machines and physical capital. They offer nations the opportunity to forge international links of production that are difficult if not impossible to break. 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 (now the Special Administrative Region of China) will be the model for the twenty-first.
The virtual state is a recent evolution, based on the prior ascent of a different form: the trading state. Led by Japan and Germany after World War II, the most advanced nations shifted their efforts from controlling territory to augmenting their share of world trade. In the 1960s and 1970s, when goods were more mobile than capital or labor, selling abroad was the name of the game. As capital has become increasingly mobile, however, advanced nations have come to recognize that exporting is no longer the only means to economic growth; one can instead produce goods overseas for both foreign and domestic markets.
Today as more production by domestic industries takes place abroad, and technology, knowledge, and capital become more important than land, the function of the state is being further redefined. The state no longer commands resources as it did in mercantilist yesteryear; rather, it negotiates with foreign and domestic capital and labor to lure them into its own economic sphere and stimulate its growth. The virtual state also locates production overseas so that it can concentrate home efforts on high-level services: research and development, product design, financing, marketing, and transport. A nation's economic strategy is now at least as important as its military strategy; its ambassadors have become foreign trade and financial representatives.
Major foreign trade and investment deals command the executive attention that political and military issues received two decades ago. The new type of international crisis is apt to resemble the frantic two weeks in December 1994, when the White House outmaneuvered the French to secure for the Raytheon Company a $1 billion deal for management of rain forests and air traffic in Brazil.
The virtual state relies 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 their activities. Unlike nineteenth-century territorial behemothsthe United States, Russia, and Germany, which aimed at omnicompetencethe virtual state does not seek to excel in all economic functions, from mining and agriculture to production and distribution. Rather, the new kind of state specializes in modern technical and research services and high-level production techniques, and derives its income not only from 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 and their associates hold the competitive key to greater wealth in the twenty-first century. In time they may supersede the continent-sized and self-sufficient units that prevailed in the past.
From Territorial to Trading States
States have traditionally been obsessed with land. The international system, with its intermittent wars, was founded on the assumption that land is key to both production and power. States could improve theft position by building empires and invading other nations to seize territory Before the age of nationalism, a captured principality willingly obeyed its new ruler; conquered provinces contained peasants and grain supplies, and their inhabitants rendered tribute to the new sovereign. The Hapsburg monarchy, Spain, France, and Russia became major powers through territorial expansion between the sixteenth and nineteenth centuries.
With the Industrial Revolution, however, capital and labor assumed new importance. Great Britain led the way in discovering sophisticated uses for the new factors of production. British machine capital turned out textiles for the world market, and English financial capital was invested abroad. At the same time, natural resourcesespecially coal, iron, and later oilfueled the Industrial Revolution. Agricultural and mineral resources stimulated the development of the United States and other fledgling industrial nations such as Australia, Canada, South Africa, and New Zealand in the nineteenth century. Capital and labormobile factors of productiondid not become paramount for these countries until late in the twentieth century.
By that time land had declined in relative value and had become harder for nations to hold. Nationalist mobilization of colonial populations has dismantled all of the nineteenth-century empires and now impedes most imperialist or invader attempts to extract resources. A nation may expend considerable effort to occupy new territory without gaining proportionate economic benefits.
Nationalist resistance and the shift in the basis of production have reduced the benefits of war. Land, which is fixed, can be physically captured, but labor, capital, and information can slip away like quicksilver after an attack. The Iraqi Army 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 continued to spend billions of dollars to resist the invasion.
Today, for the wealthiest industrial countries such as Germany, the United States, and particularly Japan, the investment in land no longer pays the same dividends. Since midcentury commodity prices have fallen nearly 40 percent relative to manufactured goods. Returns from the manufacturing trade greatly exceed those from agricultural and commodity 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.
With this decline a new political prototype, the trading state, emerged in the 1970s and 1980s. Rather than territorial expansion, the trading state sought its vocation through international commerce. The shift in national strategy was driven by the declining value of fixed productive assets. States for which a military-territorial strategy was not feasible, either because of size or because of their recent experience with conflict, also adopted trade-oriented strategies. Small European and East Asian states, Japan, and West Germany all moved strongly in a trading direction after the Second World War.
In recent years a further stimulus has hastened this change. Faced with enhanced international competition in the late 1980s and 1990s, corporations have engaged in pervasive downsizing. They have trimmed the ratio of production workers to output, saving on costs. The resulting productivity increases have lessened the widely noted gap between manufacturing and services. The corporations that survive and grow worldwide are those that can maintain or increase output with a steady or declining amount of labor.
A new kind of corporation emerged. The virtual corporation, economic analogue of the virtual state, has become increasingly pervasive. Focusing on product design, marketing, and financing, it has left production to someone else. The virtual corporation disperses its production around the world.
This new company originated in Silicon Valley. Corporations there recognized that they could enhance cost cutting, productivity, and competitiveness still further by using the production lines of other companies. The old model of fully integrated headquarters, design offices, and production lines exemplified by Ford's huge plant at Willow Run in Michigan gave way to lighter, smaller models. The comprehensive integrated structure is expensive to maintain and operate, especially in lean times when it can't run at full capacity; a firm that employs someone else's production line, however, can cut costs dramatically. Such a firm does not have to buy land and machines, hire labor, or provide medical benefits to the workers who produce its goods. It capitalizes on what are called economies of scopeturning out more than one product on the assembly line, and leasing assembly lines from other firms. The company may even design particular products for a specialized firm that performs 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 contracts out its production to other companies. Without a large investment sunk into a fixed manufacturing capacity, such a company can adapt quickly to changes in the market.
The virtual corporation is research, development, design, marketing, financing, legal, and other headquarters functions with few or no manufacturing capabilitiesa 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 (whether or not embodied in formal mergers), such as American and US Airways, Ford and Mazda, or Citicorp and Travellers, are also very profitable. According to the Financial Times, firms that actively pursue strategic alliances are 50 percent more profitable than those that do not.
From the Virtual Corporation to the Virtual State
The newly pruned corporation has facilitated the emergence of the virtual state. Downsizing has become a path to corporate efficiency and productivity gains. Now the national economy is also being downsizednot in dollar output but in productive base. Among the most efficient economies are those that possess limited production capacity at home. The archetype is Hong Kong, whose production facilities even before the transition to Chinese rule were located in southern China. Hong Kong's GDP comprises 83 percent services and about 8 percent manufacturing production. The model of the virtual state suggests that political as well as economic forces push toward downsizing at home and a relocation of production facilities abroad. In Singapore, for instance, 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, while moving local production to Malaysia and Indonesia as well as China. The virtual state is in this sense a negotiating entity that depends as much on economic access abroad as on economic control at home. Despite its past reliance on domestic production, Korea no longer manufactures everything at home, and Japanese production is increasingly lodged abroad. In Europe, Switzerland is the leading virtual nation. One example of its new focus on headquarters functions is that roughly 98 percent of Nestlé's production capacity is located elsewhere. Holland now produces most of its goods outside its borders. Britain's foreign direct investment in 1994 was almost as large as that of the United States. Even the United States participates in this trend. A remarkable 20 percent of the production of U.S. corporations now takes place outside the country.
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 finance. Services already constitute 70 percent of American GDP. Indeed, the decision to produce abroad is also a decision to concentrate at home on more highly remunerative services. In the case of the United States, 63 percent of service production occurs in the high-value category and is growing rapidly. Of course manufacturing matters, but it matters much less than it did.
Manufacturing for these developed nations will continue to decline in importance. If services productivity continues to increase, it will greatly strengthen U.S. competitiveness abroad. The United States can no longer assume, however, that services face no international competition. Efficient high-value services will be as important to a developed nation as manufacturing of automobiles and electrical equipment once was. Since 1959 services prices have increased by twenty-five times, industrial prices by sixteen times. This means that countries with a very creative and educated labor force will move increasingly into services and leave manufacturing production to emerging nations. Given highly trained labor, some nations may be able to skip the manufacturing stage and still prosper.
The world may become further divided into head and body nations, or nations representing some combination of the two. While Australia and Canada stress the headquarters or head functions, China will be the twenty-first-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 those designed, marketed, and financed by other countries. China cannot yet 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 heads. Moreover, Russia's transportation network is primitive. The Russian mafiosi are too entwined with the country's government and legal system. The Moscow government has been unable to collect enough taxes to provide basic services or to make payments on the national debt; but these are temporary obstacles. Russia, China, and India will in time serve as important loci for the world's production plant.
Economic Success and the Emancipation from Land
The world's progressive emancipation from land as a determinant of production and power gives new opportunities to emerging nations. Structures of comparative advantage that were unchangeable can now be overcome through the acquisition of a highly trained labor force. Africa and Latin America may not have to rely on exporting raw materials or agricultural products; they can develop an educated labor force such as India has in Bangalore and Ireland in Dublin. Investing in human capital, nations 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 indicate that despite overpopulation in a few countries, population density is positively correlated with wealth. The economist Deepak Lal observes that investment and growth per capita are inversely related to land holdings. This conclusion particularly derives from the current successes of small East Asian, Japanese, and European economies. Though China and India are beginning to grow rapidly, their population density does not yet approach that of smaller, highly industrialized nations. The United States and Russia have substantial endowments of raw materials, but population density is much lower, and economic growth has been variable.
These findings represent a dramatic reversal of past theories of international power. In the 1930s international relations textbooks ranked the great powers in terms of their possession of land and endowments 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 would prevail. CIA estimates of the strategic importance of various regions during the cold war were based on similar assumptions. It turns out, however, that countries with a negligible stock of natural resources are often the most prosperous? Japan, for instance, accomplished its economic miracle with little coal and no iron, bauxite, or oil. Except for rice, it imports most of its food. But Japan is richly endowed with human capital.
The implications for the United States are equally striking. As capital, labor, information, and knowledge become more important than land for economic success, America can influence and possibly reshape its pattern of comparative advantage. The New Trade theory articulated by the economist Paul Krugman focuses on path dependence: the degree to which initial design choices condition later technological development, the so-called QWERTY effect. The present QWERTY keyboard, which became standard for typewriters in the 1920s, was not the arrangement of letter-coded keys that produced the fastest typing. In fact, one of its virtues (perhaps its only one) was that by slowing typists down, it prevented keys from sticking. Now computers have succeeded typewriters, but everyone who types is trained in QWERTY; we're stuck with it. In the same way, path dependencethe way initial choices determine next stepscan influence success in developing industrial products. Nations that made the first investments in the 16-kilobyte computer memory chip used what they learned to achieve advantages in the 4- and 16-megabyte chips. Intervention at an early point in the chain of development can determine results later on; this suggests that the United States and other nations can and should deliberately alter their patterns of comparative advantage and choose their focus of economic activity.
American college and graduate education, for example, has sustained research in high technology and contributed to a very wide range of U.S. industrial choices. It has supported the decisive American 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 has been in the first twelve years of education. Unlike those of Germany and Japan (or even Taiwan, Korea, and Singapore), U.S. elementary and secondary education falls well below the world standard. This has not yet affected American advantages in high-level services, but it has influenced U.S. prowess in advanced manufacturing.
Economics teaches that products should be valued according to their economic importance. For a long period, education was undervalued socially and economically, despite productivity studies done by Edward Denison and others at The Brookings Institution 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. Yet the social and economic valuation of primary and secondary education has not appreciably increased in light of these findings. Educators, psychologists, and school boards debate how education should be structured. Administration officials bemoan the deteriorating physical plant in education. Neither invests more money in it. Corporations have sought to upgrade the standards of teaching and learning in their locales, but municipalities 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, near the salary of a starting lawyer in a New York firm. In international economic competition, human capital is the means by which states liberated from the confines of their geography have been able, with appropriate education, to transform their industrial and economic futures. A nation can choose its comparative advantage as a result of the prowess of its graduate schools, but it can only carry out its choices by better secondary education.