The Business of Private Security

World Order, Failed States and Terrorism

PART 3: The Business of Private Security

By
Henry C K Liu

PART 1: The Failed-state Cancer
PART 2: The Privatization Wave

This article appeared in AToL on March 3, 2005

The prime function of a sovereign state is the provision of security, national and domestic. National security is concerned with protection from external threats, while domestic security is concerned with maintaining social order. For the United States, protected by two oceans, the line separating external threats and homeland security had been clearly delineated until September 11, 2001, after which direct foreign threats on the US homeland became a reality. Current US policy on the threat of terrorism focuses on preemptive wars on foreign soil and preventive measures within its borders.

Notwithstanding the current high-profile concern with the "war on terrorism", it is useful and necessary to remember that the central political aim of terrorism is not to annihilate its usually overwhelmingly powerful target, but merely to draw the world's attention to what terrorists consider legitimate grievances imposed and sustained by the targeted polity and hitherto ignored by the world. Terrorism by definition is a limited reactive tactic in that it aims to make its target cease and desist ongoing injurious strategic policies and actions that have become routine and normal. Even state terrorism, also known conventionally as war, does not aim to destroy an opponent country, merely to eliminate its political resolve to resist the invader's will. The political objective of the US "war on terrorism" is to deny the legitimacy of the grievances to which terrorists aim to draw attention and to present terrorist attacks as common criminal acts. "Terrorists hate us because they hate freedom," proclaimed President George W Bush. It is not a perspective that will reduce threats to US security. The fallback tactic, then, is preemptive strikes abroad and preventive measures at home.

Such an intransigent mindset grows out of the attitude that crime should be fought with increased funding for the police rather than by funding programs to eradicate poverty. Refusal to link terrorism to injustice comes from the same mentality as refusal to link crime with poverty. Increasingly, reflecting the proliferation of such a mentality, the US seeks to meet increased national and domestic security threats from terrorism by exploiting the efficiency that allegedly can be milked from privatizing state functions. It is ironically a march toward failed statehood in its acceptance of the superior effectiveness of the private sector in performing state functions. While security protection is outsourced to market participants, little effort is devoted to promoting policies that can reduce the need for security protection. Moreover, there is clear evidence that the global proliferation of marketization of basic social services, with its effect of denying needed services to the poor, adds to the proliferation of security threats from terrorism.

Social order and social security
Social order is the main component of domestic security. Social security is the foundation of social order. Henry J Aaron of the Brookings Institution calls the US Social Security system "the great monument of 20th-century liberalism". Privatization of social security is not a solution; it is an oxymoron. It merely turns social security into private security. Neo-liberal economics theory promotes as scientific truth an ideology that is irrationally hostile to government responsibility for social programs. Based on that ideology, neo-liberal economists then construct a mechanical system of rationalization to dismantle government and its social programs in the name of efficiency through privatization. Privatization of social security is a road to government abdication, the cause of failed statehood.

In 1935, the US Congress passed the Social Security Act as part of the New Deal, in response to inevitable market failures under finance capitalism. Social Security benefit payments not only helped recipients who were too sick or too old to work, but such payments also contributed to the stabilization of business cycles that regularly wreaked havoc on the market economy. Social security was a government program that helped keep markets operational by providing a baseline level of demand with a social safety net. Starting in 1937, government receipts into the Social Security trust funds have repeatedly contributed to the reduction of the federal deficit in an era when deficit financing was indispensable to demand management, with substantial socio-economic benefits to the whole system.

The Social Security program, by its very name, is not an investment program. It is a protection program. It is not even an insurance program, because all participants receive benefits on retirement. Rates of return on investment in a market economy are direct reflections of risk levels. The concept of risk is inseparable from the prospect of worst-case eventuality. The whole purpose of Social Security is to eliminate market risk for those citizens least able to afford to risk their well-being in retirement.

The fact that Social Security payments have gradually fallen into mere supplemental support for the full financial needs of retirees does not argue for encouraging workers to taking market risks with their retirement. One-third of America's retired elderly receive 90% of their income from Social Security payments, and two-thirds receive more than 50%. This argues for increasing government contribution to Social Security costs, to be paid for by taxing unearned gains that sprang either from private control of land and other natural resources, or from the exercise of monopoly power in all its subtle forms, including overreaching intellectual property rights.

How work is taxed
Journalist Jonathan Rowe and economist Clifford Cobb conducted a study highlighting the forgotten history of US income tax by pointing out that the payroll tax, which finances Social Security, is in essence a regressive tax on work. It fell exclusively on wages and salaries of working people on the first US$90,000 of annual income in 2004. The payroll tax constitutes more than half of the federal taxes that the average US taxpayer pays. But because of the ceiling on taxable payroll income, those making more than $90,000 in 2004 paid no additional payroll tax.

The Social Security tax rate today is double the top income-tax rate in 1913, when the income tax was first introduced. In payroll taxes alone, low-income workers today are paying twice the rate that millionaires paid in the original version of the tax that Congress first enacted. Obviously, fairness demands that the income ceiling for payroll tax should be removed and the fixed rate reduced correspondingly. According to the Social Security Administration's chief actuary, if the limit on wages taxed for Social Security, currently $90,000, were lifted altogether, the system would be kept fully solvent until 2077.

In the 1920s, corporate income tax yielded almost a third of US federal revenues. Today, corporations pay just a little over one-ninth despite widespread corporatization of almost every aspect of life. The New Economy, a buzzword describing the effect of new, astronomically high-growth industries that are on the cutting edge of technology and are expected to be the driving force of new economic growth, consists of industries such as the Internet dot-coms and biotech. "New Economy" notwithstanding, a large share of corporate income is still derived from ownership of land and other natural resources, from intellectual-property monopoly and from financial manipulation. As of 1990, these comprised more than 40% of the total assets of almost a third of Fortune 500 companies. So the decline of revenue share from corporate tax has been part of the larger reversal of the basic concept behind the original income tax. It is the key venue for the sharp increase in the number of millionaires and billionaires in the US economy while more and more workers fall below the poverty line to join the rank of the working poor. It is obscene to accuse the poor of not saving enough when they do not receive even a living wage. There is no other way to reduce poverty except to give the chronic poor money and the working poor more income.

Today, the US federal tax system is in essence a tax-on-work system. It falls hardest upon income of workers and penalizes work activities that an economy needs to encourage in order to remain healthy. Capital is merely idle assets without the opportunity to generate wealth through increasing the financial value of work provided by workers. Neo-liberal economics ideology places wealth creation, as manifested in asset appreciation, as the ultimate goal of economic activities. Yet there are internal structural contradictions in the economics of wealth creation through asset appreciation, which is achievable only by causing asset value to rise faster than value of work as expressed through income. When income from work rises faster than asset appreciation, it is perceived by neo-liberal monetarists as inflation, a wealth destroyer. Thus wealth can only be created through ownership of assets the value of which rises faster than the value of work. But in reality, when asset value rises faster than income from work, those who do not own assets will fall behind into relative poverty. Thus wealth creation through asset appreciation actually produces systemic poverty. Real aggregate wealth, or the wealth of nations as Adam Smith coined it, is created only from raising the value of work as expressed through rising income from work done by the working population. Neo-liberals betray Adam Smith, their ideology guru, by usurping government's power to ensure labor of its fair share of market power, by kicking government out of its regulatory role in maintaining a truly free market, by keeping the value of work on par with the value of assets.

There is no economic logic in reducing the monetary value of work by placing a tax on it. Taxes should be derived exclusively from surplus value, ie profits. When profit is taxed, it creates incentives for management to allow wages to rise to avoid excess profit. Taxing undervalued labor values as expressed in low income from work is similar to taking food from the hungry and the undernourished. Not only is it unjust, it is also uneconomic, since any arrangement that increases poverty is bad economics. Falling value of work, a path to systemic poverty, leads to perverse ways of creating wealth, through finance manipulation to generate financial bubbles camouflaged as economic growth. This ideology of taxing the wholesome (work) to feed the insalubrious (manipulation) is aptly expressed by the chairman of the US Federal Reserve, Alan Greenspan, when he proclaims that it is better to create wealth by thinking than working, in defense of neo-liberal globalization that ships underpaying US jobs overseas to still more underpaid workers. Such economic growth produces no additional real wealth, and in fact reduces global aggregate wealth by universally reducing the value of work, leading to the unsustainable phenomenon of consumption supported by debt, primarily because work is universally underpaid. This system of tax on work burdens unfairly those already struggling hardest to make ends meet because of a systemic undervaluing of their work. When work is taxed and thinking is not, wealth can only be created with financial bubbles because all who are able will avoid work. Yet ultimately, work is what produces the goods and services that wealth commands. Thinking not backed by adequate work, coupled with overpaying thinking and underpaying work, eventually leads to an erosion of the purchasing power of money.

Yet mainstream economic policy debate rarely acknowledges this fundamental perversity. For all the partisan polemics and chest-thumping about radical tax reform, there is little debate on why the federal tax burden should mainly fall on workers. Conservatives have a point in arguing for letting taxpayers keep more of what they earn, but they adamantly oppose taxation on unearned gains arising from the mere ownership of capital, land and other natural resources and intellectual-property monopolies, the high value of which are all derivatives of dysfunctionally low wages. The US capital-gain tax is a revenue sieve with a hole large enough for truckloads of gold to pass through undetected since much wealth nowadays is created by manipulating debt, involving no capital at all.

Accounting for an ethical society
It is useful to realize that the problem with the US Social Security system is not an economic issue. It is a political/ethical issue with a financial dimension. The economics of Social Security remains structurally sound. The problem is one of irrational and dishonest financial accounting. It is an ethical verity that a civilized society should assume responsibility for providing institutional guarantee for its elderly citizens' financial needs after retirement, particularly if retirement is made mandatory by the socio-economic system. In a sense, Social Security is inseparable from US national security, because social stability is a key component of national security. If Social Security is viewed as part and partial of national security, then privatization becomes as ridiculous a notion as privatizing the Department of Defense - which, incidentally, is also occurring with deliberate speed.

On November 11, 1999, the 80th anniversary of the World War I armistice, Milton Friedman, the leading guru of the Chicago School monetarists, published an op-ed piece in The New York Times titled "Social Security chimeras" in which he pointed out, correctly, that the Social Security trust funds and projected shortfalls and all the sturm und drang noise surrounding them are, in fact, mere accounting issues. He pointed out that, in real economic terms, it doesn't matter whether Americans save or not, whether there's a shortfall or not, points that most economists understand and agree. It is merely an accounting problem.

As Fed chairman Greenspan recently and repeatedly told Congress, funding Social Security benefits with cash is not a problem. The problem is maintaining the purchasing power of the cash. But the purchasing power of money is a systemic monetary issue, and not an accounting issue of any particular social program. Money enjoys more purchasing power when more goods and service are produced by work and work is created by strong demand for goods and services. What Greenspan did not say was that such strong demand comes only from high wages and full employment.

Friedman went on to argue that gradual, partial privatization of Social Security is unnecessary, since gradualist solutions are premised on attempts to "preserve" what amount to fictional balances anyway. But then, following his subjective ideology rather than his objective analytical mind, Friedman proposed what is in essence an ideological solution, one that is antisocial, as are most of his ideological positions in essence, crossing over from his respected role as a competent economist to the dubious role of a bungling political philosopher. Why not, he concluded, go all the way? Full, complete privatization right now. Let every citizen swim or sink in the market, where those not thoroughly initiated in its esoteric ways have as much a chance of survival as babes in a forest of dangerous beasts. What about today's Social Security recipients? Give them a check representing the present value of their promised benefits and wash our hands of them.

But Friedman did not explain why, if the shortfalls are mere accounting problems (which they are), why Social Security has a problem in the first place. Why not drop the whole argument and reaffirm our social commitment to a decent public pension system for all citizens, along with universal health care, the privatization of all of which is ruining many families? This question is particularly pertinent in a situation of underutilized overcapacity due to inadequate aggregate demand.

Faith and inefficiency
There is a fallacy about the magic of privatization. It is based on an unjustified faith in the market's unerring ability to generate wealth and growth and, more important, in the market's ability to channel such wealth fairly and to parties most in need for the good of the nation and society. Increasingly, markets are transfer mechanisms of wealth rather than creators of wealth, merely taking wealth from underpaid workers and handing it over to overpaid speculators. The fact is that markets have also been known to be generators of losses and economic contraction, as demonstrated by the crashes of 1901 (45% drop), 1906 (48%), 1916 (40%), 1929 (47%), 1930 (86%), 1937 (49%), 1939 (40%), 1968 (46%), 1973 (46%), 1987 (23%) 1998 (36%) and 2000 (37%). The data suggest that even exempting the big crash of 1929-30 in which the market lost nearly 90% of its peak value, the average crash can routinely lose 40% of its peak value. Such losses are often not borne by speculators, who can profit in both rising and falling markets, but mostly by the general investing public, whose portfolios are usually not hedged against systemwide declines. And even in cycles of growth, the market has a tendency to channel wealth to those who already have substantial wealth and least need more. The average investor seldom benefits fully even from a rising bull market.

In this era of instant electronic transactions and computerized program trading, eliminating market "inefficiencies", more than risk commensuration, produces most of the profits on Wall Street. Theoretically, under free-market principles, it should be unnecessary to have to choose the smart investment because all instruments are "priced" the Hayekian way to make return on investment come out equal in the long run, risk being always fairly compensated for with commensurate returns. When they do not come out equal, the situations are called market inefficiencies, which are in fact disjointed minor market failures. So, by definition, all opportunities for profit reside exclusively on correcting market inefficiencies and reducing risk by socializing it. This is what justifies the existence and proliferation of hedge funds and derivatives. They make the market more efficient and are richly compensated for it.

With increasing sophistication and complexity of new marketable financial instruments, be they securitized debt or equity or derivatives, the astute and legally qualified risk takers have a distinct advantage over the unaware and unqualified general public. This advantage constitutes a massive, systemic transfer of wealth to those who are rich enough to qualify for high-net-worth entrance requirements of hedge funds and private equity markets to a game of taking technical risks that are really not risky because of sophisticated hedging, to reap enviable and often obscene gains of up to 40% on investment. This systemic market transfer of wealth to the rich is greater than any government social-entitlement transfer to the poor. That is how millionaires are made into billionaires in the market, not by luck, not by skill, but by membership in the private club of the rich in what investment bankers call the private-equity sector. It is a blatant institutionalization of the "rich get richer" syndrome. It is the new feudalism.

Yet unlike the old feudal lords who provided order and security, or inventors or captains of industry who actually performed some positive economic function, these groups of the financially astute contribute not at all to economic production, only to financial expansion, a euphemism for finance-induced economic bubbles. The sad part is that in the US, this market is attracting the best and brightest of the nation's young minds, who are individually moral and ethical, but collectively are pushed by the system into the role of terrifying horsemen of financial apocalypse. They destroy because the name of the game is "creative destruction" and the highest reward goes to the one who destroys the most - jobs, companies, even whole industries. It is as if firemen were to get a handsome bonus several hundredfold of their salary every time they put out a fire, and if it were not illegal to start a controlled fire, all firemen would double as controlled arsonists. Controlled arson can be rationalized as economically expansionist, as it leads to constant rebuilding when it is most profitable, albeit not always where it is most needed by society. But then Margaret Thatcher insisted that there is no such thing as society.

This is the equivalent of what Wall Street traders do, in equity, debts, commodities, currencies, even weather derivatives. Whenever they can, they purposely create market inefficiencies in order to capture profit by removing the very "inefficiencies" they created. Citigroup, the world's largest financial-services company, is being investigated by German prosecutors and the Financial Services Authority for a manipulative multibillion-euro trade in euro-zone government bonds last August when it sold and then bought billions of euros' worth of debt in quick succession, making millions of euros in profit. According to news reports, a Citibank internal memo dated July 20 explained how the bank could "very profitably" destabilize the market.

The current normal daily volatility of stock prices represents ongoing examples of these manipulated inefficiencies. A whole science of technical analysis of market movements has grown up around the phenomenon. Others are less directly visible, such as the inverted interest-rate curves reflecting abnormal lower rates for longer terms that generally signals recessions ahead. It is a short-term inefficiency in the credit market imposed by Federal Reserve interest-rate policy. The Fed controls the supply of money but the market determines the growth of debt. As yields stay low, investors are pushed to seek higher yields by taking more risk, buying debts with low credit ratings. Since 2003, the Fed has been raising the Fed Funds Rate at a "measured pace", but the debt market has continued to expand, with yields on both sovereign and corporate bonds declining. Low-rated bonds now make up 20% of the outstanding supply of speculative bonds, more than twice the 1998 level when the Asian financial crisis and the Russian default abruptly ended the debt bubble. Consumer spending has been largely supported not by income, but by home-equity loans, particularly cash-out refinancing, at below-inflation interest rates.

The current Social Security proposals in the United States only highlight these pervasive manipulations that have gone on for a decade. Ironically, the Social Security privatization proposals are really sub-optimization measures, because, like the debacle of Long Term Capital Management (LTCM) that almost led to a massive collapse of the market, which required Federal Reserve intervention to prevent, when massive Social Security funds go into the equity market, it will be deemed too big to fail even if the market turns against it. So there is an anticipated implicit guarantee by the US Treasury/Federal Reserve that with Social Security funds in it, the market will not be allowed to crash, which is why Wall Street will embrace privatization proposals with open arms. It is a game where profits are privatized, and losses are socialized. In that sense, the US economy is already half-socialistic: the loss half. The question is: when is it going to socialize the profit half for balance?

The most significant factor of the booming war economy in the US during World War II was that about 10 million able and productive men, 25% of the workforce, were taken out of economically productive work and had to be supported at a high level of military consumption. In fact, another way of looking at it is that these soldiers were assigned the job of consumption. The lesson is that by a deliberate collective effort, an enormous expansion of production was effectuated through a planned war economy of full employment for a reduced pool of workers. Ironically, the new high-tech wars of today of minimizing manpower will reduce even the economic bonus of war on employment and the effectiveness of war as an anti-depression economic measure.

With a policy of full employment and rising wages, there is no reason the US economy cannot support its expanding population of retirees at a decent living level of consumption even with a shrinking pool of workers. Changing demographics, while factual, is not the cause of the problem in Social Security. Faulty ideology is. Young workers should be reminded that it is their parents' retirement consumption that will allow them to keep their own jobs with high pay.

Evolution of taxation
The first permanent US corporate income tax was enacted in 1909, four years before the introduction of the modern version of the personal income tax. The initial rate was 1% of net income. Both revenue and rate increased steadily until 1943, when it peaked at 7.1% of gross domestic product (GDP). But corporate income taxes have contributed a declining portion of federal revenue over the past six decades. This decline has been made up by the increasing share of revenue from social-insurance contributions, primarily the Social Security payroll tax. In 1943, corporate taxes comprised 39.8% of total federal revenues; social-insurance contributions contributed 12.7%. By 1996, the situation was nearly reversed; social-insurance contributions provided 35.1% of federal revenues, while corporate income taxes provided 11.8%. The Tax Reform Act of 1986 reduced corporate income tax from 46% to 34%, well below the 42% average rate of developed countries in the Organization of Economic Cooperation and Development. In the US, state corporate tax rates made up most of the difference.

The US economy grew faster than OECD economies, but the income of the lower quartile in the US declined in the past six decades. US prosperity had been paid for by making the poor poorer in the US and around the world. The US corporate tax rate stayed at 34% until the Clinton administration's first budget raised it to 35%. Meanwhile, with neo-liberal globalization promoted by Third Way politicians such as Bill Clinton and Tony Blair, tax competition among developed economies was driving worldwide corporate tax rates toward a downward spiral in a race toward the bottom, leaving the tax burden mainly on the working poor everywhere. Together with the race-to-the-bottom effect on wages from cross-border wage arbitrage, the global downward spiral of corporate tax rates causes a decline in government revenue and distress in government fiscal budgets, creating temptation for selling off public assets in a massive wave.

By 1994, the United States' 35% corporate tax rate was above the average OECD statutory rate of 29%. That meant that US-based trans-nationals would keep their profits overseas and save 6% in tax liabilities. In 1994, US corporate tax revenues amounted to just 2.5% of US GDP, a sharp drop from its 7.1% peak in 1943. The Tax Reform Act of 1986 eliminated many corporate tax preferences, including the investment tax credit enacted during the administration of president John Kennedy. However, preferential tax treatment is still provided for expenditures on research and development.

But while the creation of intellectual property is financed by tax deductions, the consuming public is not given any break on exorbitant patent royalties. This injustice is most glaring in the US drug sector, where high costs of drugs have driven many elderly patients into financial distress, drugs that their own tax dollars helped create earlier.

The payroll taxes that finance Social Security and Medicare are levied at a flat rate. For Social Security, the tax is 12.4%, half of which is remitted by workers and half by their employers. For Medicare hospital insurance, the tax is 2.9% divided equally between workers and employers. Workers earning more than the $90,000 threshold in 2005 will pay no Social Security tax on amounts over that, but the ceiling does not apply to the Medicare portion of the payroll tax.

The Social Security tax is highly regressive. Those earning $10 million a year pay the same Social Security tax as workers earning up to $90,000, and the rich receive a greater share of their income from investment earnings that are not subject to the payroll tax. And the person with a $10 million retirement nest egg receives the same benefit payment as the person with no nest egg.

Arguments for and against progressive taxation generally focus on income taxes, which can be easily manipulated to shift burdens among households with different levels and types of income. Advocates of progressive schedules argue that families should be taxed according to their ability to pay. The ability-to-pay principle states that each dollar paid in tax is a greater sacrifice for a poor family than a wealthy one, so the wealthy should pay a higher percentage to equalize the sacrifice. Moreover, a progressive income tax is needed to counteract the effects of the other flat federal taxes that weigh more heavily on the poor. The poor pay most of their taxes in payroll taxes, thus income-tax reform has little real meaning to the poor.

Many economists also argue for progressive scheduling as a way to counteract the increasingly structural inequality distribution of income in the US economy. The share of income received by the top quintile increased from 47% to 51% of all income in the US over the 1977-90 period, while the share going to everyone below declined. One-fifth of the working population commanded more than half of the income in the economy. Take-home wages have been declining as a share of total personal income, to a historical low of only 55%, because the cost of benefits, particularly health care, and payroll taxes have taken larger shares of total income of workers. Higher-income families also increased their real incomes substantially over this period, while families in the bottom 40% of the income distribution saw their incomes decline in real terms. In other words, those with the lowest incomes not only received an increasingly small share of the total income relative to the wealthy over this period, but the purchasing power of their incomes declined as well.

According to the "ability-to-pay argument", the dramatic increase in income inequality in the US in recent years indicates a need for more progressive tax scheduling, because the rich have become more able to pay relative to the poor. According to this argument, if "the problem is flat wages, then the solution is not flat taxes". Compliance rates are highest for wage and salary income, because these taxes are withheld by employers and forwarded directly to the Internal Revenue Service (IRS). On the other hand, compliance rates for self-employment, partnership, and sub-chapter S corporation income, which are not subject to withholding or reporting requirements, are estimated to be below 50% due to difficulty and complexity of audit. Because companies can deduct interest payments, the US tax code is strongly skewed toward encouraging firms to raise funds through the issuance of debt rather than equity. The tax-paying general public is in effect subsidizing corporate debt.

Another issue related to corporate taxation is the wide variation in tax liability from industry to industry. The effective tax rates in the oil, gas, and mineral-extraction industries, for example, are much lower than the rate for corporate investments generally. The commercial real-estate boom of the mid-1980s and subsequent bust was largely the result of preferential tax treatment. One of the main causes of the 1987 crash as explained by tax economists was a threat by the House Ways and Means Committee to eliminate the tax deduction for interest expenses incurred in leverage buyouts. These tax variations can be inefficient from a societal perspective, even though they were intended to address specific needs, because the resources used to build unneeded office space, drill dry holes in the ground, and merge companies to lay off workers could have been used more productively. The Tax Reform Act of 1986 eliminated some of the provisions that led to these types of distortions, but many still remain.

For the three-year period from 1996-98, Alcoa, the chief executive officer of which, Paul O'Neill, was secretary of the Treasury briefly under President George W Bush, paid an effective tax rate of only 15.9% on $1.7 billion in profits - less than half the statutory rate of 35%. A US worker making up to $58,100 is taxed at 15%, after which the rates rises progressively to 35% for income over $319,100.

The outsourcing question
Despite widespread perception of massive job loss to low-wage economies, there are no official figures on the total number of US jobs that have gone overseas. Domestic plant closures to be relocated overseas are no longer reported in the media as they are no longer news. Last May, the Labor Department made its first-ever report on the portion of "mass layoffs" attributable to "overseas relocation" of factories, which showed that only 2.5% of major layoffs in the first three months of 2004 were a result of outsourcing abroad. That survey only covered companies that laid off 50 or more workers at one time for 30 days or longer, and so admittedly may not be representative of all companies and all job loss.

Veteran Democratic economist Charles Schultze, senior fellow emeritus at the Brookings Institution, former budget director under president Lyndon Johnson in the 1960s, and former chairman of president Jimmy Carter's Council of Economic Advisers in the late 1970s, noticing that imports relative to the GDP had leveled off since 2000, concluded that "there is nothing in the data to suggest that large increases in ... offshoring could have played a major role in explaining America's job performance in recent years", and that offshoring has had a relatively modest impact on unemployment when compared with all the other economic factors that create and destroy jobs in the normal cycles in the US economy. But Schultze failed to point out that US GDP growth is caused in no small way by a persistent capital account surplus that is financing the massive US trade deficit. In other words, the US economy is creating new jobs to replace those lost to overseas outsourcing by borrowing from the low-wage workers overseas.

There is clear evidence that the US is trading low-paying jobs that it ships overseas for new higher-paying jobs at home. This explains the widening income disparity in the US economy and in the world economy. Offshore outsourcing has contributed to the stagnant wages and declining benefits in the US labor market.

Ben Bernanke, chairman of the economics department at Princeton University and also a governor of the Federal Reserve, estimated that over the past decade the US economy lost an overall total of about 15 million jobs each year for all kinds of reasons, while creating an average of about 17 million new jobs each year. Of that 15 million annual gross job loss, the portion due to outsourcing is less than 1%. Bernanke cited a 2003 study by the Wall Street firm of Goldman, Sachs & Co that estimated outsourcing abroad had averaged between 100,000 and 167,000 jobs per year since 2000. And he said offshoring would remain a minor factor even if the figure grew larger. Of course the study did not mention that by 2000, most of the manufacturing jobs that could be relocated overseas had been relocated, with the US having lost in essence the entire manufacturing sector.

When companies move some jobs abroad, the savings from low wages stimulate job creation at home. Matthew Slaughter, a Dartmouth economist, looked at foreign and domestic job growth in multinational corporations from 1991 to 2001 and found foreign affiliates of US companies added 2.9 million workers to their payrolls overseas, but at the same time those companies added 5.5 million US employees at home to their payrolls. And a study supervised by Lawrence Klein, a Nobel laureate and professor emeritus at the University of Pennsylvania's Wharton School of Business, and released by the private economic consulting firm Global Insight last March, looked at outsourcing in the information-technology (IT) sector and found that outsourcing generated a net gain of 90,000 jobs during 2003, in both IT and non-IT sectors.

Notwithstanding such findings, the question of why US unemployment stays so high remains unanswered. There are few job seekers in the United States who will challenge the general feeling that the job market has become increasingly gloomy, with wages low and benefits meager if offered at all. Still, the Klein study found that the cost savings of IT outsourcing lowered inflation throughout the US economy, increased consumer spending, and "contributed significantly" to the overall growth of US GDP. It claimed that by 2008, "real GDP is expected to be $124 billion higher than it would be in an environment in which offshore IT... outsourcing does not occur". Klein seemed uninterested in which segment of the population would get the projected additional GDP growth - surely not the workers whose jobs had been outsourced.

Democratic presidential candidate John Kerry pointed out correctly during his unsuccessful 2004 campaign that the US tax code creates an incentive for US companies to move jobs overseas. He tried unconvincingly to pin the fault on Bush. But tax experts know that the incentive has been there for decades, embedded even in the first version of the corporate income tax. The incentive exists because the US has been taxing corporations at rates higher than most other countries. This was possible before trade and finance globalization, when the huge US market could only be tapped by operations within US borders. Companies that wanted access to the huge US domestic market had no choice but to pay high US corporate taxes. The fault of tax-induced job loss lies with globalization, which the Clinton administration did much to promote. It allows trans-national companies to locate in low-tax regimes around the globe.

The Institute for International Economics reported that the effective rate for US corporations was more than 30% in 2002, while Britain's corporate rate was 18.2%, Mexico's 15.1%, China's 11.3%, and Indonesia's a minuscule 0.2%. In tax havens such as Hong Kong, the concept of residence has no applicability to Hong Kong tax law. Only Hong Kong source income is subject to Hong Kong tax. For this reason, Hong Kong is a suitable base from which to administer an offshore company without tax consequence provided that the company does not do business with other Hong Kong residents. This is one of the reasons the use of offshore companies by Hong Kong residents has proliferated to such a great extent. Offshore companies can conveniently have Hong Kong-based directors, a Hong Kong bank account and a Hong Kong office address without being brought into the Hong Kong tax net.

Most other countries of the world operate a residency-based tax system, and care therefore needs to be taken to ensure that the offshore company does not establish a permanent place of business within those countries or is managed and controlled from those countries. For example, an offshore company that had UK-based directors or that established a place of business within the United Kingdom might become liable to UK tax on its worldwide income. A Hong Kong company does not have to state its registered office address or place of incorporation on its letterhead. This would give the non-Hong Kong offshore company the added respectability of a Hong Kong persona combined with the added flexibility and ease of administration of an offshore company. There is a capital duty of 0.6% and an annual fee of HK$75 (just under US$10). There are no double tax treaties and no restrictions on dealings in currencies. Bearer shares are not permitted, registration takes three weeks, but shelf corporations are readily available.

The United States taxes US-based company earnings in other countries only when profits are brought back to the US. That means profits that remain overseas, perhaps invested in new factories in low-tax regimes, never get taxed at the higher US rates. And that's been true through both Democratic and Republican administrations. To fix the tax problem, Kerry came up with a proposal to tax businesses on their foreign income right away. Corporations would still get a credit for any taxes paid to other countries, as they do now, but would no longer be able to defer the US taxes indefinitely. At the same time, Kerry would have cut the corporate tax rate by 1.75 percentage points, to a top corporate rate of 33.25%. He also would have offered a one-year "tax holiday" to businesses that repatriated earnings that had been parked overseas for years, avoiding all US taxes. And he proposed a tax credit to companies when their US hiring exceeded previous levels. But Kerry did not win the election.

The Bush administration proposes giving US-based multinationals a larger tax credit on their overseas income. Democrats argue that this would only increase the incentive to move jobs overseas; the Bush administration argues that it would help US firms compete globally with foreign firms that avoid US taxes altogether. Yet companies argue that the main reasons they locate plants in other countries are lower wages and proximity to foreign markets, not taxes.

High US corporate tax rates discourage US companies from repatriating foreign-earned profits and reinvesting them into the US economy. A study produced by economists at JPMorgan Securities Inc estimates that the promise of a temporary window of a 5.25% corporate tax rate on overseas earnings could prompt US companies to bring home as much as $300 billion in foreign-earned profits, now sitting offshore. Thus a more equitable tax regime domestically, ie making corporations pay their fair share of taxes, harms the US economy as a whole. In other words, globalization forces the US economy to be a less equitable system. To put it another way, domestic income disparity is explained as a necessary condition for national survival in a competitive international arena.

If allowed by the absence of government regulations, trade tends to shift resources to industries where worker productivity relative to wages is greatest and return on investment highest. The same goes for technology. In the past, the limited and temporary dislocation caused by import competition had been outweighed by lasting long-term benefits that competition creates because superior imports forced complacent domestic industries to shape up, as evident by the US auto industry in the 1980s. Also, a substantial majority of US non-farm workers, about 85%, are employed in service industries, construction, and government, sectors where import competition was minimal and restriction on immigration and tradition of unionization foiled effective wage wars among competing workers. To such workers, imports were unambiguous blessings that spurred domestic innovation, expanded consumer choice, and lowered consumer prices.

Even in the more tradable sector of manufacturing, import penetration was low in most industries where domestic assembly was necessary. By 1994, however, 2.2 million US workers worked in manufacturing industries with an import penetration of 30% or more, most in the assembly of imported parts. Even so, workers in trade-sensitive manufacturing industries accounted for only 12% of total manufacturing workers and less than 2% of total non-farm workers. Technological change and other non-trade factors account for most of the workers displaced from their jobs each year. In the three-year period from 1995 through 1997, three-quarters of the 8 million US workers displaced from their jobs were in sectors that by their nature are relatively insulated from import competition. Only 23% were in manufacturing, and 2% in mining and agriculture.

But while the figures seem insignificant in national terms, job loss was significantly concentrated in terms of location to affect economic stability drastically in several regions, such as the rust belt in the Midwest and miracle growth areas such as Silicon Valley. Surging imports created demands in freight transportation, but hourly wages fell 0.8% nationwide. Retail jobs increased but weekly wages in the retail sector ($376), already 30% less than the national average, fell more than 11% in 2004, while corporate profit rose by 20%.

But outsourcing is a new and fast-growing phenomenon and is rapidly changing the dynamics of growth. With instant and low-cost communication, non-import-related service jobs are being lost at alarming rates in the name of a quest for productivity relative to wages. US customers of domestic sales now place their orders with US companies through employees halfway across the world for goods produced in low-wage economies and often shipped directly from foreign soil. In other words, jobs were going to offshore workers only because their wages were lower, not because they were better workers. That is rational only if the economic objective is to increase productivity relative to wage levels. What if the economic objective is to increase wages? The market will never by itself allow wages to increase unless government policy forces it to do so. And each government cannot do so within its own borders under a globalized regime of racing to the bottom with regard to wage competition. Thus a global contagion of failed statehood is in full swing in which governments are forced to abdicate their responsibility to protect the wage level and job security of their citizens, lest jobs would move to another country. Sovereign governments have become comprador governments.

A two-year study by the United Nations' labor organization produced a report that identified globalization as creating a growing divide between rich and poor countries, as well as a growing divide within every country. The report found that the current trading regime, including the World Trade Organization, is failing to speed the growth of global gross national product (GGNP), which is lagging behind the economic performance of previous decades. Titled "A Fair Globalization", the study was commissioned by the International Labor Organization and prepared by 20 officials and experts, including Joseph E Stiglitz, the newly reformed US economist who won the 2001 Nobel Prize in economics (see Globalizing poverty, IMF style, November 16, 2002). The report found that 188 million willing and able workers are unemployed worldwide, or 6.2% of the labor force; that the gap between rich and poor nations has widened, with countries representing 14% of the world's population accounting for half the world's trade and foreign investment; and that women have been harmed more than men by globalization in the developing world. The report also said that women's traditional livelihoods as subsistence farmers or small producers have been undermined by foreign subsidized agriculture or foreign imports but, as women, they face cultural barriers when looking for alternative occupations. These are the economic manifestation of failed statehood.

The gap between rich and poor has grown wider in rich countries as well, such as Britain, Canada and the United States. The United States posted the greatest gap between rich and poor, with the top 1% earning 17% of the gross income, "a level last seen in the 1920s". The report says that globalization has also affected the rate of taxes collected by countries. In the world's 30 wealthiest nations, the average level of corporate tax fell from 37.6% in 1996 to 30.8% in 2003. These rich nations may be rich but they are nevertheless infested with failed-state syndrome with their widening wealth disparity. The report argues that globalization is at a turning point and international institutions need to address social inequities as well as other consequences of open borders, which render sovereign states powerless to protect their citizens from economic and financial exploitation, both foreign and domestic.

During the seven years from 1995 through 2002, US manufacturing employment fell by 11%. Globally, manufacturing jobs fell by 11%. China lost 15% of its manufacturing jobs, and Brazil lost 20%. Globally, manufacturing output rose by 30% during the same period. Technological progress was the primary cause of the decrease in manufacturing jobs. Yet wages have not risen to reflect the rise in productivity. Most of the saving in wages for the same amount of production went to financing the cost of capital goods and higher return on capital. US workers are targeting the wrong enemy when they complain about Third World workers taking their jobs. The real enemies are their own pension funds, whose quest for high returns has kept global wages low and shipped US jobs overseas, and their government's failed statehood.

That same principle applies when outsourcing serves as the engine for not-so-creative destruction. Daniel W Drezner, assistant professor of political science at the University of Chicago, defending outsourcing in "The outsourcing bogeyman" (Foreign Affairs, May/June 2004), reports that for every dollar spent on outsourcing to India, the US economy reaps between $1.12 and $1.14 in financial benefits. US firms save money on wages and become more profitable, benefiting shareholders and increasing returns on investment. In the process, some US workers are reallocated to more competitive, mostly better-paying jobs, albeit seldom the same workers who were unfortunate enough to have lost their jobs. They are left as collateral damage of creative destruction concentrated in pockets of poverty in the land of milk and honey.

On February 9, 2004, US presidential chief economic adviser N Gregory Mankiw, who resigned just last month to return to his faculty post at Harvard, released the annual Economic Report of the President, praising offshoring of US service jobs as a "good thing". He told reporters that "outsourcing is just a new way of doing international trade". Government may try to protect you from incoming missiles, but don't expect government to protect your job.

Globalization and instability
In the era of financial globalization, nations are faced with the problem of protecting their economies from financial threats. The recurring financial crises around the world in recent decades clearly demonstrated that most governments have failed in this critical state responsibility. The economic benefits associated with the unregulated transfer of financial assets, such as cash, stocks and bonds, across national borders are frequently not worth the risks, as has been amply demonstrated in many countries whose economies have been ravaged by external financial forces. Cross-border capital flows have become an increasingly significant part of the globalized economy over recent decades. The US depends on it to finance its huge and growing trade deficit. More than $2.5 trillion of capital flowed around the world in 2004, with more than $1 trillion flowing into just the US. Different types of capital flows, such as foreign direct investment, portfolio investment, and bank lending, are driven by different investor motivations and country characteristics, but one objective stands out more than any other: capital seeks highest return through lowest wages. The United States is not only losing jobs to lower-wage economies, the inflow of capital also forces stagnant US wages to fall in relation to rising asset values.

Countries that permit free capital flows must choose between the stability provided by fixed exchange rates and the flexibility afforded by an independent monetary policy to stimulate economic growth. In countries with weak financial and legal institutions, poorly regulated banking systems or high levels of corruption, capital inflows may not be channeled to their most productive uses. One approach to limiting the risks from excessive capital flows when legal and financial institutions are inadequate is to restrict foreign capital inflows. Even in the US, which claims to have a sound banking system, massive capital inflow has caused overinvestment in telecommunication, Internet start-ups and real estate.

Next: Failed statehood, militarism and mercenaries