Terror times eight: TIE asked an important international strategist to list, beyond terrorism, the major looming threats to the international economy.

Tarullo, Daniel K.

Some consequences of the September 11th terrorist attacks are near certainties: The multi-front campaign against terrorism will be the centerpiece of U.S. foreign policy in the foreseeable future. An already shaky economy has been tipped into recession. The American psyche has been traumatized. Beyond these basics, little is yet clear. Will the campaign against terrorism provoke a fundamental change in how key nations assess their interests and formulate their policies, or will it simply accelerate trends and tendencies that were already in evidence? Will the United States and global economies bounce back after some period of uncertainty, or will a significant "security premium" be effectively imposed on most economic transactions, resulting in sizeable cost increases that retard growth indefinitely? Will Americans respond by trying to close the country's doors, or will they commit to greater international cooperation against common threats?

With all these unknowns, it is exceedingly premature to predict whether the events of September 11th will, a half century from now, appear as a watershed in American history, much less the nature of such a watershed. In the midst of our grief over the loss of life and our sense of everyday security, we do well to remember that the United States continues to have a range of global interests. Though they may have receded from the consciousness of top policymakers and mass-market commentators, they are still important. They will move front and center again someday. Even as the nation responds to the fact and threat of terrorist attacks, we must pay heed to these risks and opportunities, lest they too catch us unawares.

The aftermath of the terrorist attacks has been a grim reminder that security developments can dramatically affect economic performance. But causation can move in the other direction as well. That is, long-term economic trends, both favorable and unfavorable, can themselves create foreign policy challenges and security crises. What follows is a list, in no particular order of likelihood, of eight latent foreign policy problems arising from economic developments. Because most of these longer-term concerns are more likely to materialize in a prolonged period of sub-par economic performance, they are very much related to the immediate question of how the world will change in reaction to the terrorist attacks.

Deterioration of South American Economies. This is perhaps the most obvious item on my list, but no less important for all its obviousness. Argentine and Brazilian economic difficulties of the last year or two have already revealed how conditional the embrace of market-oriented economic policies has been in much of South America. The admirable resolve of those countries to overcome rampant inflation in the early 1990's does not necessarily convert to a commitment to maintain austerity policies in the face of disappointing growth. To the contrary, if the policies preached by the United States and the IMF are not seen as promoting equitable growth, they may be abandoned. Further, there is a risk that some members of the middle and working classes may associate liberal democratic values with the market-oriented values of the "Washington consensus" and reject both.

A Collapse of World Energy Prices. Possibilities that the Afghan war may spread westward or that a revolution may occur in an oil-producing nation suggest that the biggest short-term oil risk may be that of vastly higher prices. But if these unwelcome political contingencies are avoided, oil prices are as likely to collapse as rise. At first glance this may seem like cause for celebration, rather than a harbinger of problems. But there is a difference between prices that are low within the range of prices that has prevailed in recent years, and a collapse of prices below that range. Depressed prices would, of course, most likely occur against the backdrop of a recession that severely limited demand for oil and natural gas. Thus the good news for consumers would be more than offset by unemployment and falling incomes. At the same time, the revenue declines for Middle Eastern energy-producing states would seriously threaten the stability of the already vulnerable regimes of Saudi Arabia and some of the Gulf states. By spreading their oil wealth around their countries (and, to some degree, the region) those states have thus far held at bay both fundamentalists and democracy advocates. Without the wealth to do so, this fragile situation may come unglued, with potentially severe consequences for regional stability and oil supplies.

Financial Collapse in Japan. Japan has drifted in and out of recession for a decade. Several times during the Asia crisis, the Japanese financial system seemed in danger of collapse, but was held together with some patchwork policy measures and a dose of luck. We have now lived with these risks for so long that there is a tendency to downplay them. Yet the banking system is still burdened with so many trillions of yen in bad and questionable loans that it is not clear the system as a whole is solvent. The high levels of Japanese government debt constrain its ability to bail out the banking system. In the event of an extended worldwide recession, a collapse could not be ruled out. The economic consequences of the period before and after a collapse could themselves be serious, as Japanese banks and companies repatriated assets held abroad in order to meet their liquidity needs. The security repercussions could be equally severe if, as seems likely, Japan turned further inward, leaving a regional vacuum once occupied by a strong American ally and the world's second largest economy.

Chaos on the Korean Peninsula. A further potential source of instability in Asia rests in North Korea. This is another situation in which the persistence of a problem that has not erupted may breed complacency. Though reliable information about North Korea is notoriously hard to come by, the economics of the country are at best very tenuous, and at worst a disaster. Should the regime disintegrate, the results could include a wave of refugees that would overwhelm South Korea, economically and socially. North Korea's population is both poorer and more numerous relative to South Korea's than was East Germany's population relative to West Germany's in 1990. The largely benign, though still taxing, process of German reunification is unlikely to be repeated in Korea. Meanwhile, chaos on the peninsula could tempt other Asian powers to intervene, with potentially destabilizing consequences.

Rapid Ascent of China's Economy. This is another development that looks at first glance to be largely benign. After all, the world is sorely in need of engines of economic growth, and a growing China may provide one. Moreover, the emergence of a Chinese middle class will, in the view of many analysts, create more pressures for political liberalization. While one or both of these effects may in fact be realized, a fast-growing China poses foreign policy challenges as well as opportunities. The debate over whether a rising, self-confident China will be more aggressive or more accommodating is a well-worn one that need not be repeated here. Less discussed are the implications for the rest of Asia of a China that moves rapidly up the value chain of manufacturing. With a workforce that is highly skilled for a country with its per capita income, China may soon be the locus of choice for manufacturing semiconductors, mobile phones, automobiles, and other industries. At least for a time, the lure of relatively low-wage, high-skilled labor could decimate FDI prospects in other East Asian countries. If the political and regulatory climates loosen enough, Hong Kong could eclipse Singapore as the prime regional financial center and Shanghai could displace Kuala Lumpur, Taipei, and Seoul as regional bases for multinational companies. Though principles of comparative advantage dictate that it won't be efficient for China to produce everything, it may take some time for production patterns to sort themselves out, and a rapid Chinese economic ascent up the value chain may not give other countries time to adjust. During that transition period, the East Asian tigers accustomed to rapid growth may face challenges far more daunting than those of the 1997-98 financial crisis. Again, internal political instability raises the chances for external political and even military conflict. Needless to say, a weakened Taiwan would raise the prospect for a crisis of an entirely different order of magnitude.

An Economically Decelerating China. Ironically, the opposite factual assumption also gives grounds for concern. To date, China has weathered remarkably well both the financial crisis of the late 1990's and the global slowdown of 2001. Recall predictions just a few years ago from supposed China experts that the weight of the state-controlled firms on the banking system would limit China's growth and perhaps lead to an implosion of the whole economy. Doubts were also raised as to whether China's economic reforms would stall. None of these dire prospects has been realized, of course. Still, structural problems have not been solved, and China is surely not immune to a prolonged economic slump in the markets of its best customers. Were China not able to sustain improvements in its standard of living, the rather substantial regional and political tensions that have heretofore been contained by the Chinese leadership could produce internal disarray with consequences that are hard to foretell but unlikely to be pleasant, for China or for the rest of the world.

Balkanizing Political Units. In the wake of the terrorist attacks there has been much speculation that international economic integration will be arrested or even reversed, as a "security premium" is effectively levied on all international transactions--longer delays in customs entry, tighter entry and immigration controls at the border, costly security measures for air and other transport services. But suppose that, as with the proliferation of energy savings innovations after the oil crises of the 1970's, these costs decline within a few years, as governments and market actors alike learn how to achieve security at a lower cost. Assuming that globalizing tendencies revive, we may witness an acceleration of the political balkanization that has been apparent in recent years. While the creation of new nations out of old has many causes--historic national identities, the demise of empires (including the Soviet Union), civil war--the creation of more and smaller political units is facilitated by economic integration. As national economies blend into regional or global markets, it is easier for a Quebec or a Scotland to envision an economically feasible independence. So too, the existence of global institutions such as the IMF and the WTO made the early life of a post-Soviet republic far more promising than might have been the case a few decades ago. The spread of such balkanizing tendencies, whatever their appeal as a realization of aspirations for self-determination, may create internal political crises in some U.S. friends and allies. Also, if these tendencies in fact result in more and more small countries, it will be increasingly difficult to achieve the positive and effective cooperation among governments necessary to address everything from international terrorism to money laundering to global cartels.

Aging Industrial Democracies. Unlike each of the preceding concerns, the aging of the populations of the industrial democracies is a fact, rather than a possibility. The resulting strains upon pension and health care systems will soon be apparent in Japan, already beset by so many travails. Later, Europe and then the United States will confront less dramatic, but still serious variations on this demographic challenge. Aging societies will drain increasing portions of their national product to transfer payments and health care. While many solutions to the demographic challenge suggest themselves (for example, increased immigration, higher retirement ages), each is very controversial and thus not easy to realize. The foreign policy concern is that a secular trend towards lower economic growth will ensue, and thus threaten the underpinnings of the military and economic strength of the United States or, more likely, some of its closest allies.

These eight concerns by no means exhaust the range of possible foreign policy problems arising from economic developments. One might, for example, easily add the continued exclusion of much of Africa from the global economy, which immeasurably complicates the struggles against famine, poverty, and AIDS. But the eight issues I have highlighted do suggest two general conclusions.

First, while the identification of a potential problem with an economic genesis does not mean that economics alone can solve it, six of the eight potential dangers can be mitigated by solid economic growth. For example, greater political participation may be necessary for long-term political stability in the Gulf States in any case, but a healthy economy may allow the changes to be relatively peaceful. The manifold foreign policy problems lurking behind economic distress underscores still further the importance of continued and competent attention to both the short-term task of restarting world growth and the longer-term task of creating a stable and fair framework for the international economy. While the security concerns that now grip us are obviously preeminent, we must remain aware that the costs of depressed economic activity will themselves include national security threats.

Second, four of my eight potential dangers are grounded in Asia. Two relate to China alone. This pattern reinforces the view that there is no more pressing foreign policy challenge than how the United States deals with China over the next decade. As then-Senator Sam Nunn insightfully observed in a speech on the eve of a congressional vote on extending most-favored-nation tariff treatment for China, history is littered with examples of established powers failing to manage successfully their relationships with rising powers. If there is any good at all that can come from the horror of September 11th, perhaps it is that cooperation between China and the United States in addressing the shared threat of terrorism will provide ballast to the overall relationship and increase mutual accommodation in other arenas. In any case, the China relationship must be attended closely behind the scenes, even as terrorism holds center stage.

Whether or not there are further terrorist acts on American soil, the nation will understandably be consumed with its response and its efforts to mend the national psyche. But the American interests that existed on September 10th are still American interests. The worries that prevailed on September 10th are still worries. Even as the country steels itself for a protracted and dangerous campaign, we must remember that in foreign policy--unlike military policy--we cannot afford to plan for only two or two and a half conflicts at a time.

Daniel K. Tarullo is a Professor of Law at Georgetown University law Center. Mr. Tarullo is also a Senior Fellow at the Council on Foreign Relations. From 1993 to 1998, he served in the Clinton administration as Assistant Secretary of State for Economic and Business Affairs, Deputy Assistant to the President for Economic Policy, and Assistant to the President for International Economic Policy.