The Sovereign Economic Model. A manifesto for rising nations

Sovereign Economic Margins

Let us suppose a carmaker in Country 1 that produces and sells a cool million units of $100,000 cars. It has produced $100 billion in products. As a finished good, this number will count toward GDP. Consider two scenarios:

1. All suppliers are building all of the vehicles’ parts in the country, but said business activity is not included in GDP calculations because it is the last stage of production.

2. All suppliers’ parts are built in another country, so the production of cars is counted in Country 1 as $100 billion of GDP and the suppliers’ business is counted as $70 billion of GDP in Country 2 because it is the last stage of production in that country.

In Scenario 1, $100 billion is counted, all-inclusive, while in Scenario 2, $100 billion is counted for Country 1 and $70 billion is counted for Country 2, a total of $170 billion.

What happened in reality? In Country 1, $30 billion of wealth was created; in Country 2, $70 billion was created. So Country 1 was credited with $100 billion of GDP, but only created $30 billion of wealth. In fact, Country 2 produced 70 percent of the wealth, more than double that of Country 1.

The Sovereign Economic Model prefers to focus on wealth creation and not just meaningless GDP numbers. This concept can be called the sovereign economic margin. That is why, with industrialization and import substitution policies, wealth is created. It happens with the production of final goods and the sub-production of intermediate goods or parts within a country. Anything built in another country and imported is wealth for the producing foreign country. Employment is wealth. Employment implies the use of labor for useful productive activities, so the more productive workers, the more wealth creation increases. Evidently, not all employment means doing productive tasks; some types even destroy wealth, such as in these cases:

• The cost of employment is higher than the wealth produced (e.g., communism).

• Bureaucracy is slowing down wealth creation.

• Wealth is offset by productive activities with high adverse social costs.

As with any other improvement process, the reduction of defects, i.e., unproductive economic activities, is a significant step in the right direction.

Wealth Creation Instead of GDP as a KPI for Economic Policies

Understanding the principles of wealth creation allows governments to devise economic policies and related legal and fiscal frameworks to stimulate creation and creators of wealth. Also, their policies must rein in wealth wasters and wealth destroyers. While GDP is easier to count and show off, it is a highly unreliable accounting method. It is often abused and massaged to suit political needs. Unexpectedly, Japan’s longtime manipulation of GDP numbers was recently exposed. Wealth creation is unquestionably a more precise indicator.

There are four horsemen of wealth creation:

1. Labor, with raw resources, is an essential input for production that transforms resources from natural elements into intermediate or finished goods. It includes both physical and intellectual work. Tools, machinery, and equipment can help increase the amount of production a worker can output. This increase is called productivity.

2. Raw resources, with labor, are essential inputs for production as the basic building blocks to manufacture any category of goods. They may be either natural elements or energy sources.

3. Capital is an important catalyst of production. It finances increased labor, raw resources, or knowledge to produce a larger number of items or items with a higher value, creating superior levels of wealth. Capital by itself cannot be wealth.

4. Knowledge allows the production of increasingly complex, higher-wealth products. High-tech industries need input from thousands of highly educated and skilled specialists. Knowledge can therefore be a consequence of long experience doing a particular job.

These four input factors create wealth. Offshoring manufacturing and production moves the wealth creation process to those countries. In times when a knowledge economy prevails, offshoring outsources the knowledge and teaches it to a potential competitor, so it is always a bad idea in the long term.

Business Environment in a Sovereign Economic Model

«What’s in for me?» is the question most ask. For every rule and regulation, people and business evaluate the changed status quo and ask this question. While the government tries to use carrot and stick and to balance pros and cons with the interests of various stakeholders, the fact of life is that some will win and some will lose.

In state capitalism, the government takes ownership or majority control of companies in strategic sectors of the economy. This creates a big headache for private companies in that sector, who are asking what’s in it for them. If the state-owned enterprises are non-aggressive and compete fairly, not using specially biased laws in their favor, competition is normal, as with other private companies. They may sometimes even collaborate to create common tech or cooperate with foreign operations. In fair conditions, the government is interested in a tide that lifts all boats. This is the case in Russia, with Novatek as the largest LNG exporter and Lukoil as the second-largest oil company; both companies happily coexist with state giants Gazprom and RosNeft. On the contrary, if the government behaves aggressively and moves into some sectors, companies and their owners must drastically adapt. Some might even have to sell a majority stake or the entire company at a fair market price because they cannot resist the onslaught from the government.

In the Sovereign Economic Model, the economic KPI is wealth creation. The sectors producing wealth are agriculture (first sector of the economy), industry (second sector) and the knowledge economy (quaternary sector). Therefore, these fields will receive the most state support, effort, and attention. Industrialization, exports, and import substitution are policies meant to drive real production and thus the real economy. Consequently, the service sector will not get preferential treatment. Similar activities that do not bring prosperity to the country and its people are also excluded. Economic policies should favor large capital flows into wealth-creating industries and out of less productive ones. Inefficient industries and unproductive industries will suffer the most as the state limits and curtails them. Such a situation is noticeable in China, where the government has cut back on economic excesses, speculation, and other systemic imbalances.

Each rule change produces winners and losers. If a government implements economic policies favoring the wealth creation KPI, there will be a set of winners and losers.

The winners

• People will win as increasing employment and wider wealth distribution give them a more comfortable lifestyle.

• Governments will win as increased production brings greater tax revenue and consequently more well-balanced budgets.

• Agriculture, infrastructure, industry, and high tech will win as they will be the net receivers of government attention, subsidies, and lower taxes.

• The service industry will win as more people will have surplus wealth to spend on a variety of services, such as vacations, entertainment, and personal care.

The losers

• Companies relying on rent-seeking businesses will lose out against government.

• Financial services will lose as unproductive investments and mere accumulation will be curbed.

• Products and services promoting unproductive activities will be restricted.

• Economic activities with high social costs will be regulated strictly. Examples:

• Taxation of sodas and junk food, coupled with a de-taxation of healthy or less unhealthy foods

• Taxation of ecologically polluting materials

Economic policy creation and changes must consider potential winners and losers. A government can, with prior notice and support, steer the businesses in new directions.

How to Apply the Sovereign Economic Model by Level of Development

The Sovereign Economic Model contains concepts that have usually been applied in developed nations when they were developing and emerging countries themselves. Most countries have had to protect their markets, such as the US at the end of the 19th and beginning of the 20th centuries; most European countries after World War II; Japan and South Korea slightly later; and many countries in Africa and Latin America in the 1960s and 1970s when, after being colonies, they became independent.

Countries in the developing phase should focus on these priorities:

• Agriculture, natural resources, and infrastructure

• Low-to-medium-technology industry

• One high-tech industry as a national priority

Emerging countries should ponder the following policies:

• Maintain the focus on agriculture, natural resources, and infrastructure.

• Increase focus on the high-value medium-high technology industry.

• Focus on at least one high-value high-tech industry as a national priority.

• Start focusing on the knowledge economy.

Even developed nations, as they stand, have not completed their evolution curve. Many argue that they have started a regression in the past decade, like a playground swing in a park hitting its peak below potential, then stopping and moving backwards. Over-financialization has crept in, and the focus on their core industries and wealth-creating economic sectors has been lost. Speculative investments and other unproductive allocations of money have created more industries of hype than ever. The valuation of assets is wrongly given a higher priority than production, employment, and profits. Government policies and national economic KPIs have changed to achieve quick Pyrrhic victories in perception, but not substance or progress. The toxic addiction to debt, especially long-term debt, is sapping wealth as government interest payments. Unfortunately, debt produces a near-zero percentage of GDP increase and no wealth. In many companies with legendary heritage, products have been watered down and their intrinsic quality and value characteristics flushed out to increase sales and maximize production. The management of developed countries and their business itself is being distracted by ever-increasing marginal issues and useless new fads. Actions of management are big announcements, costs, and time wasted, but without concrete changes or results moving the economic wagon forward. Inefficiencies have crept into the system through outdated infrastructure, outdated processes, and outdated systemic operators, both government and connected business. Bureaucracy and red tape in many countries still require people to transport paperwork in person. People need to visit five different agencies in five different offices during office hours instead of communicating through an online system, which can process such data in a few seconds or minutes at any time of day or night. Education systems have softened to adapt to these new realities instead of insisting on meritocracy and improving the academic curricula, and levels have been lowered by the Bologna Process and Common Core curricula. Rigorous academic tradition was thus demoted to let anyone take part instead of maintaining rigor through an academic selection process.

To roll back, most countries need to take stock and refocus on the core systemic issues of their economies. Cures for rotting economies are needed. It is hard to take stock of bad habits and reassess priorities, but it needs to be done. A list of action steps will need to be prepared and started to change the status quo and introduce new best practices. The following might be some of these steps:

• Increase speed and efficiency of government services for business and people.

• Remove inefficient and unproductive capital allocations from the market.

• Return to conservative economic policies with frugal use of debt.

• Change economic KPIs and steer government support toward them.

• Rebuild infrastructure to include the latest technologies.

• Keep the focus on wealth-generating economic sectors: agriculture, natural resources, infrastructure, industry, and the knowledge economy.

• Return the focus to high-value, high-wealth industry sectors.

• Focus on at least one high-tech industry as a national priority.

• Revert the education system to old-style meritocracy, but implement new-style curricula to support the wealth-creating industry sectors first.

Depending on the stage of development and structure of their economy, countries need to implement economic policies that benefit their real economic growth.

Clarity of Vision and Policies Is the Key

As changes occur, communication of such policies needs to occur in advance to spell out the vision, and the rules need to be clear and detailed. It should function similar to a car’s turn signals, which indicate the direction the car will take in the road and future ahead. A country doing just that is China. Its five-year plan programmatic document perfectly delineates the country’s vision, directions, and action plan in the years ahead. By taking this step, businesses can avoid being unprepared and may even ask for help to align themselves with the new rules. Clarity of vision and clear communication are essential to decrease criticisms and uncertainty.

State capitalism

That which is not good for the beehive cannot be good for the bees.

– Marcus Aurelius, Roman emperor and philosopher, AD 161—180

State Capitalism as Guided Capitalism

State capitalism is usually wrongly associated with communism. In that system, the state owns any type of business activity with central planning of labor and input/output. Communism has been shown as effective only in certain situations with heavy crises or a war economy. In that context, the state needed to direct all resources and lots of production in a predetermined direction, such as rearmament or postwar recovery and reconstruction. Mostly forgotten is the use of state capitalism in the post-war recovery of Europe and East Asia after World War II. Then, state-led development corporations and state-owned enterprises (SOEs) rebuilt economies ravaged by war.

Despite its supposed similarity to communism, all countries practice some form of state capitalism, or economic interventionism. Some openly admit and carry it as part of a national economic model. Such countries might be from the former Soviet or communist bloc, or countries formerly associated with the USSR. Some less advanced countries also favor employment over other economic factors. Self-declared liberal countries apply ad hoc economic interventions for corporations «too big to fail» or «too important to fail,» or they apply corporate welfare to please extremely powerful lobbies, which results in various forms of economic distortion. Here the state uses subsidies, regulations, and price controls to help national companies, erect non-tariff hurdles to ward off foreign competition, and fix prices to protect an industry or wages (minimum wage) that secure some social stability. Tax credits, tax incentives, and tax exemptions are used to support business sectors or regional areas or to help establish new industries. For example, in the green energy business, less environmentally friendly fuels and fossil fuels are penalized. Regulations can elevate local standards in ways that leave foreign companies struggling to keep up or require huge expenses to realign. Others, especially those with wealth created by natural resources like oil, gas, and mining, have created sovereign wealth funds to hoard profits from the extraction industries.

Another good reason for state capitalism is that the government can act similar to the spring in a car’s shock absorber and like a rudder on the economy to absorb economic shocks and volatility and to steer some business practices. For example, a government can require the use of certain national technologies to improve the economy instead of letting companies choose. This might not be efficient in the short term, and it may cost some private companies’ profits, but it can be a winning strategy in the long term because such policies ultimately build up domestic industries. It is a trick to effectively make some industries subsidize others.

Is state capitalism too top-down? One mistake of communism is its desire to control all business activity, down to individual small businesses. State capitalism instead wants to control the major strategic sectors of the economy and regulate some others. Instead, in non-strategic sectors, such as light industry and services, the sovereign state should make rules that foster innovation and competition. This can be accomplished through low taxes and regulations, strong competition, and antitrust law. Other measures, too, are implemented to allow business to flourish without interference.

Capital, the Real Economy, and Wealth Creation in State Capitalism

Capital is a required element for wealth creation. State capitalism, by ownership and control of strategic industries, makes sure that capital, as profits, gets reinvested in industries that create wealth. State capitalism effectively monopolizes rent-seeking industries and market sectors, which produce most capital in the form of profits and dividends. A state can use that profit to reinvest in the real economy’s industries and reduce non-working capital in the economy.

Through such investment, state capitalism can be an effective strategy for economic development. One shortfall of liberal capitalism is that it is not aligned with the needs and strategic direction of a country: private businesses just chase profit or money accumulation. Usually in liberal capitalism, this is obviated by legislation and taxation to encourage private businesses to invest and enter a specific market segment. This investment is rarely encouraged to effectively meet a need, but more for declaring success by showing off highly questionable GDP numbers. In capitalism, money, like water, flows where there is less resistance and gives higher returns. So investors prefer to invest in fast food or coffee chains instead of in big industrial enterprises, which come with higher risk, longer production times, and fewer returns. Money, like water, can flow where it is unnecessary, where it does not bring benefits to the country, its people, and the wider local community. More refined forms of state capitalism as practiced in the Sovereign Economic Model are comparable to the management of water resources, such as riverbeds, basins, and coasts. Water, like money, must be directed in ways that create not disasters, but benefits to the local community.

State Capitalism 3.0 is the latest upgrade and current version. At the present moment, it is viewed as the third version after two iterations in the 19th and the 20th centuries. Currently, it is practiced to meet the following goals:

• Protect the financial markets from globalization and foreign ownership.

• Create a central bank to protect the national banking institutions.

• Progress development to the level of the most advanced countries.

• Establish a hybrid state capital.

• Promote state-led capital accumulation.

Several types of state capitalism exist. It has many forms, depending on the country and mindset:

• Some are derived from geopolitical issues, with sanctions and trade wars pushing a country to adopt passive or active forms to fight off foreign countries and their companies.

• Ideological state capitalism is more inclined to stabilization and socially relevant topics like protection of society from financialization and globalization.

• Protectionist state capitalism is more preoccupied with defending the market from foreign invasion.

• Competitive state capitalism uses this form to compete, often unfairly, with other countries.

No prescribed model of state capitalism exists and there is no formula to define which is best or even what works. The best model to use is tailor-made for the country and brings the greatest benefits to its economy.