The New State Capitalists

In May 2009, as the worst of the global financial crisis appeared to be passing, I joined a small group of economists and scholars to discuss the fallout with China's Vice Foreign Minister He Yafei at the Chinese Consulate in Manhattan. He began the meeting with a blunt question: "Now that the free market has failed," he asked, "what do you think is the proper role for the state in the economy?"

His mischievously matter-of-fact tone almost drew a laugh, but the question was a serious one—and a glance at the headlines offered him plenty of corroborating evidence. The bankruptcy of Lehman Brothers and other Wall Street giants had underlined the historic scale of the financial crisis. Political officials in Washington had assumed responsibility for decisions normally made by markets in New York, a momentous shift in economic and financial power from America's capital of finance to its capital of politics. President Bush had created the $700 billion Troubled Asset Relief Program, only to see the recession gain speed. His successor, Barack Obama, warned that if Washington didn't move quickly, America faced a catastrophe. Lawmakers responded with a $787 billion rescue plan.

He Yafei waited patiently for an answer. Over the next 90 minutes, my colleagues and I made our case for free-market capitalism, and Mr. He made his for a capitalism driven by the state. We found some limited common ground, but as the meeting ended, it was clear we had argued the respective merits of two fundamentally incompatible sets of political and economic principles.

In meetings of much greater consequence now taking place around the world, this inability to agree on the proper role for the state will change the way we live. It's now a G20 world, in which China, Russia, Saudi Arabia, and other state-centric players wield growing influence. When leaders of free-market democracies diagnose the global meltdown, they now face the skeptical smiles of those who believe that the free market has failed and that the state should play the leading role in guiding national economies.

How did we get here?

The collapse of communism did not mark the final triumph of free-market capitalism because it did not put an end to authoritarian government. Chinese state officials watched Russia's post-Soviet upheaval and learned some important lessons. They accepted that if they failed to generate prosperity, their days were numbered, but that the state can't simply order up economic growth. Only by releasing the entrepreneurial energies of its vast population could China thrive and the party survive. The Communist Party needed to embrace market capitalism while protecting its monopoly on power by ensuring that the state controlled the lion's share of the wealth that markets generate.

Authoritarian governments everywhere have learned to compete by embracing capitalism. But they know that if they leave it entirely to market forces to decide winners and losers from economic growth, they risk enabling those who might use the new wealth to challenge their political power. State capitalism allows governments to use various kinds of state-owned companies to manage the exploitation of resources like oil and natural gas to create and maintain large numbers of jobs. National oil companies now own more than three quarters of the world's crude oil reserves. Governments also use both state-owned and politically loyal private companies to dominate strategic sectors like aviation, power generation, arms production, and telecommunications. To finance these companies, governments often use sovereign wealth funds, state-managed pools of foreign cash that allow them to protect their currencies, control price inflation, spread their economic risks, and project political power. Sovereign wealth funds draw capital from various sources. For Russia, the Persian Gulf Arab states, and several North African countries, there is the revenue earned from oil and gas exports. For China, there is the cash earned from the export of manufactured goods to the United States, Europe, and Japan. What makes the funds different—and poses challenges for free markets—is that their managers answer to political officials, not shareholders.

Through the use of state-owned companies, privately owned national champions, and sovereign wealth funds, the state uses markets to create wealth that can be directed as political officials see fit. In all three cases, the ultimate motive is not maximizing growth but maximizing state power and the leadership's chances of survival. The state doesn't always exert day-to-day control over these institutions, but it has considerable direct influence. The main characters in this story are the men who rule China, Russia, and the Arab monarchies of the Persian Gulf. But the apparent success of this new model has attracted imitators throughout much of the developing world.

There is nothing new about state-owned companies and investment funds. China has had state-owned companies for decades. OPEC was generating international headlines in the early 1970s. Sovereign wealth funds began appearing in the 1950s. The difference is not in the institutions themselves but in their importance for international politics and the global economy. Until the end of the Cold War, the communist world's isolation imposed sharp limits on the global economy's production capacity, but economic trends within it had little negative impact west of the Iron Curtain. Today, we're wired together as never before.

The financial crisis and market meltdowns in America and Europe have given state capitalism a big boost. In part, that's because Western economies are still struggling to their feet while China is again off to the races. It's now much harder for Westerners to champion a free-market system and easier for China and Russia to argue that only governments can save economies on the brink. After all, government spending has been essential for recovery in both America and China. In China, that spending has reinforced state capitalism, because most of the money went to state firms. In all of its dimensions, including construction of roads, bridges, and power grids, the reconstruction of earthquake-ravaged Sichuan province, and the purchase of shares in troubled banks, Beijing's recovery effort favored state over private firms. Now, many state-owned enterprises with newly strengthened balance sheets are buying private-sector rivals. Beijing is using its financial muscle to build state-owned oil and gas companies into global players, by allowing them to borrow directly from the state's massive foreign-exchange reserves, at a moment when cash-strapped multinationals can least afford to compete.

For now, the financial crisis has provided Beijing with new evidence that enlightened state management will protect them from the natural excesses of free markets. This experiment will likely expand, and continue to exert a growing influence on the shape of the global economy, until it generates a new crisis of its own.

Excerpted from The End of the Free Market: Who Wins The War Between States And Corporations? By Ian Bremmer by arrangement with Portfolio, a member of Penguin Group (USA), Inc. Copyright © Ian Bremmer, 2010.