The Rise of the Virtual state Richard Rosecrance TERRITORY BECOMES PASSE AMID THE supposed clamor of contending cultures and civiliza- tions,a new reality is emerging.The nation-state is becoming a tighter,more vigorous unit capable of sustaining the pressures of worldwide competition.Developed states are putting aside military, political,and territorial ambitions as they struggle not for cultural dominance but for a greater share of world output.Countries are not uniting as civilizations and girding for conflict with one another. Instead,they are downsizingin function if not in geographic form.Today and for the foreseeable future,the only international civilization worthy of the name is the governing economic culture of the world market.Despite the view of some contemporary ob- servers,the forces of globalization have successfully resisted partition into cultural camps. Yet the world's attention continues to be mistakenly focused on military and political struggles for territory.In beleaguered Bosnia, Serbian leaders sought to create an independent province with an al- legiance to Belgrade.A few years ago Iraqi leader Saddam Hussein aimed to corner the world oil market through military aggression against Kuwait and,in all probability,Saudi Arabia;oil,a product of land,represented the supreme embodiment of his ambitions.In Kashmir,India and Pakistan are vying for territorial dominance over RICHARD RosECRANCE is Professor of Political Science and Director of the Center for International Relations at the University of California, Los Angeles. [45] Copyright 2001.All Rights Reseved
Richard Rosecrance a population that neither may be fully able to control.Similar rival- ries beset Rwanda and Burundi and the factions in Liberia These examples,however,look to the past.Less developed coun- tries,still producing goods that are derived from land,continue to covet territory.In economies where capital,labor,and information are mobile and have risen to predominance,no land fetish remains. Developed countries would rather plumb the world market than ac- quire territory.The virtual state-a state that has downsized its terri- torially based production capability-is the logical consequence of this emancipation from the land. In recent years the rise of the economic analogue of the virtual state-the virtual corporation-has been widely discussed.Firms have discovered the advantages of locating their production facilities wherever it is most profitable.Increasingly,this is not in the same lo- cation as corporate headquarters.Parts of a corporation are dispersed globally according to their specialties.But the more important devel- opment is the political one,the rise of the virtual state,the political counterpart of the virtual corporation. The ascent of the trading state preceded that of the virtual state. After World War II,led by Japan and Germany,the most advanced nations shifted their efforts from controlling territory to augmenting their share of world trade.In that period,goods were more mobile than capital or labor,and selling abroad became the name of the game.As capital has become increasingly mobile,advanced nations have come to recognize that exporting is no longer the only means to economic growth;one can instead produce goods overseas for the foreign market. As more production by domestic industries takes place abroad and land becomes less valuable than technology,knowledge,and direct investment,the function of the state is being further redefined.The state no longer commands resources as it did in mercantilist yester- year;it negotiates with foreign and domestic capital and labor to lure them into its own economic sphere and stimulate its growth.A na- tion's economic strategy is now at least as important as its military strategy;its ambassadors have become foreign trade and investment representatives.Major foreign trade and investment deals command executive attention as political and military issues did two decades [46] FOREIGN AFFAIRS Volume 75 No.4
The Rise of the Virtual State ago.The frantic two weeks in December 1994 when the White House outmaneuvered the French to secure for Raytheon Company a deal worth over $1 billion for the management of rainforests and air traffic in Brazil exemplifies the new international crisis. Timeworn methods of augmenting national power and wealth are no longer effective.Like the headquarters of a virtual corpora- tion,the virtual state determines overall strategy and invests in its people rather than amassing expensive production capacity.It con- tracts out other functions to states that specialize in or need them.Imperial Great Rather than amass Britain may have been the model for the nineteenth century,but Hong Kong will land,capital,and labor, be the model for the zist. virtual states set strategy The virtual state is a country whose economy is reliant on mobile factors of and invest in people. production.Of course it houses virtual corporations and presides over foreign direct investment by its enter- prises.But more than this,it encourages,stimulates,and to a degree even coordinates such activities.In formulating economic strategy, the virtual state recognizes that its own production does not have to take place at home;equally,it may play host to the capital and labor of other nations.Unlike imperial Germany,czarist Russia,and the United States of the Gilded Age-which aimed at nineteenth-century omnicompetence-it does not seek to combine or excel in all eco- nomic functions,from mining and agriculture to production and distribution.The virtual state specializes in modern technical and research services and derives its income not just from high-value manufacturing,but from product design,marketing,and financing. The rationale for its economy is efficiency attained through produc- tive downsizing.Size no longer determines economic potential. Virtual nations hold the competitive key to greater wealth in the 2ist century.They will likely supersede the continent-sized and self-sufficient units that prevailed in the past.Productive special- ization will dominate internationally just as the reduced instruction set,or"RIsc,"computer chip has outmoded its more versatile but slower predecessors. FOREIGN AFFAIRS July/August 1996 [47] Copyright 2001.All Rights Reseved
Richard Rosecrance THE TRADING STATE IN THE PAST,states were obsessed with land.The international sys- tem with its intermittent wars was founded on the assumption that land was the major factor in both production and power.States could improve their position by building empires or invading other nations to seize territory.To acquire land was a boon:a conquered province contained peasants and grain supplies,and its inhabitants rendered tribute to the new sovereign.Before the age of nationalism,a cap- tured principality willingly obeyed its new ruler.Hence the Hapsburg monarchy,Spain,France,and Russia could become major powers through territorial expansion in Europe between the sixteenth and nineteenth centuries. With the Industrial Revolution,however,capital and labor assumed new importance.Unlike land,they were mobile ingredients of pro- ductive strength.Great Britain innovated in discovering sophisticated uses for the new factors.Natural resources-especially coal,iron,and, later,oil-were still economically vital.Agricultural and mineral re- sources were critical to the development of the United States and other fledgling industrial nations like Australia,Canada,South Africa,and New Zealand in the nineteenth century.Not until late in the twenti- eth century did mobile factors of production become paramount. By that time,land had declined in relative value and become harder for nations to hold.Colonial revolutions in the Third World since World War II have shown that nationalist mobilization of the population in developing societies impedes an imperialist or invader trying to extract resources.A nation may expend the effort to occupy new territory without gaining proportionate economic benefits. In time,nationalist resistance and the shift in the basis of produc- tion should have an impact on the frequency of war.Land,which is fixed,can be physically captured,but labor,capital,and information are mobile and cannot be definitively seized;after an attack,these resources can slip away like quicksilver.Saddam Hussein ransacked the computers in downtown Kuwait City in August 199o only to find that the cash in bank accounts had already been electronically transferred. Even though it had abandoned its territory,the Kuwaiti government could continue to spend billions of dollars to resist Hussein's conquest. [48] FOREIGN AFFAIRS Volume 75 No.4
The Rise of the Virtual State Today,for the wealthiest industrial countries such as Germany,the United States,and Japan,investment in land no longer pays the same dividends.Since mid-century,commodity prices have fallen nearly 40 percent relative to prices of manufactured goods.1 The returns from the manufacturing trade greatly exceed those from agricultural exports.As a result,the terms of trade for many developing nations have been deteriorating,and in recent years the rise in prices of in- ternational services has outpaced that for manufactured products. Land prices have been steeply discounted. Amid this decline,the 197os and 198os Before downsizing,the brought a new political prototype:the trading state.Rather than territorial ex- typical American firm pansion,the trading state held trade to be had headquarters, its fundamental purpose.This shift in na- tional strategy was driven by the declining factories,and land. value of fixed productive assets.Smaller states-those for which,initially at any rate,a military-territorial strategy was not feasible-also adopted trade-oriented strategies. Along with small European and East Asian states,Japan and West Germany moved strongly in a trading direction after World War II. Countries tend to imitate those that are most powerful.Many states followed in the wake of Great Britain in the nineteenth century; in recent decades,numerous states seeking to improve their lot in the world have emulated Japan.Under Mikhail Gorbachev in the 198os, even the Soviet Union sought to move away from its emphasis on mil- itary spending and territorial expansion. In recent years,however,a further stimulus has hastened this change.Faced with enhanced international competition in the late 198os and early 199os,corporations have opted for pervasive downsiz- ing.They have trimmed the ratio of production workers to output, saving on costs.In some cases productivity increases resulted from prun- ing of the work force;in others output increased.These improvements have been highly effective;according to economist Stephen Roach in a See,for example,Enzo R.Grilliand Maw Cheng Yang,"Primary Commodity Prices, Manufactured Goods Prices,and the Terms of Trade of Developing Countries:What the Long Run Shows,"The World Bank Economic Review,1988,Vol.2,No.1,pp.1-47. FOREIGN AFFAIRS July/August 1996 [49] Copyright 2001.All Rights Reseved
1994 paper published by the investment banking firm Morgan Stanley,they have nearly closed the widely noted productivity gap between services and manufactur- ing.The gap that remains is most likely due to measurement problems.The most efficient corporations are those that can maintain or increase output with a steady or declining amount of labor.Such corporations grew on a worldwide basis. Meanwhile,corporations in Silicon Valley recognized that cost-cutting,productivity,and competitiveness could be en- hanced still further by using the production lines of another company.The typical American plant at the time,such as Ford Motor Company's Willow Run factory in Michigan,was fully integrated,with headquarters,design offices,production work- ers,and factories located on substantial tracts ofland.This com- prehensive structure was expensive to maintain and operate, hence a firm that could employ someone else's production line could cut costs dramatically.Land and machines did not have to be bought,labor did not have to be hired,medical benefits did not have to be provided.These advantages could result from what are called economies of scope,with a firm turning out different products on the same production line or quality circle. Or they might be the result of small,specialized firms'ability to perform exacting operations, such as the surface mounting of miniaturized components directly on circuit boards without the need for soldering or con- ventional wiring.In either case,the original equipment manufacturer would WEYA contract out its production to other firms. [5o] FOREIGN AFFAIRS Volume 75 No.4 wRooOT
scI Systems,Solectron,Merix, Flextronics,Smartflex,and Sanmina turn out products for Digital Equipment, Hewlett-Packard,and IBM.In addition, AT&T,Apple,IBM,Motorola,MCI,and Corning meet part of their production needs through other sup- pliers.TelePad,a company that makes pen-based computers, was launched with no manufacturing capability at all.Compaq's latest midrange computer is to be produced on another company's production line. Thus was born the virtual corporation,an entity with research, development,design,marketing,financing,legal,and other head- quarters functions,but few or no manufacturing facilities:a com- pany with a head but no body.It represents the ultimate achievement of corporate downsizing,and the model is spreading rapidly from firm to firm.It is not surprising that the virtual corporation should catch on.“Concept'”or“head”corporations can design new products for a range of different production facilities.Strategic alliances between firms,which increase specialization,are also very profitable.Accord- ing to the October 2,1995,Financial Times,firms that actively pursue strategic alliances are so percent more profitable than those that do not. TOWARD THE VIRTUAL STATE IN A sETTING where the economic functions of the trading state have displaced the territorial functions of the expansionist nation,the newly pruned corporation has led to the emerging phenomenon of the vir- tual state.Downsizing has become an index of corporate efficiency and productivity gains.Now the national economy is also being downsized.Among the most efficient economies are those that pos- FOREIGN AF FAIRS July/August 1996 [5] Copyright 2001.All Rights Reseved
Richard Rosecrance sess limited production capacity.The archetype is Hong Kong, whose production facilities are now largely situated in southern China. This arrangement may change after 1997 with Hong Kong's reversion to the mainland,but it may not.It is just as probable that Hong Kong will continue to govern parts of the mainland economically as it is that Beijing will dictate to Hong Kong politically.The one country-two systems formula will likely prevail.In this context,it is important to remember that Britain governed Hong Kong politically and legally for nso years,but it did not dictate its economics.Nor did this arrange- ment prevent Hong Kong Chinese from extending economic and quasi-political controls to areas outside their country. The model of the virtual state suggests that political as well as economic strategy push toward a downsizing and relocation of pro- duction capabilities.The trend can be observed in Singapore as well. The successors of Lee Kuan Yew keep the country on a tight politi- cal rein but still depend economically on the inflow of foreign factors of production.Singapore's investment in China,Malaysia,and elsewhere is within others'jurisdictions.The virtual state is in this sense a negotiating entity.It depends as much or more on economic access abroad as it does on economic control at home.Despite its past reliance on domestic production,Korea no longer manufac- tures everything at home,and Japanese production(given the high yen)is now increasingly lodged abroad.In Europe,Switzerland is the leading virtual nation;as much as 98 percent of Nestle's produc- tion capacity,for instance,is located abroad.Holland now produces most ofits goods outside its borders.England is also moving in tandem with the worldwide trend;according to the Belgian economic historian Paul Bairoch in 1994,Britain's foreign direct investment abroad was almost as large as America's.A remarkable 20 percent of the produc- tion of U.S.corporations now takes place outside the United States. A reflection of how far these tendencies have gone is the growing portion of GDp consisting ofhigh-value-added services,such as concept, design,consulting,and financial services.Services already constitute 7o percent of American GDP.Of the total,63 percent are in the high- value category.Of course manufacturing matters,but it matters much less than it once did.As a proportion of foreign direct investment,ser- vice exports have grown strikingly in most highly industrialized [52] FOREIGN AFFAIRS Volume 75 No.4
The Rise of the Virtual State economies.According to a 1994 World Bank report,Liberalizing International Transactions in Services,"The reorientation of [foreign direct investment]towards the services sector has occurred in almost all developed market economies,the principal exporters of services capital: in the most important among them,the share of the services sector is around percent of the stock ofoutward and that share is rising." Manufacturing,for these nations,will continue to decline in im- portance.If services productivity increases as much as it has in recent years,it will greatly strengthen U.S.competitiveness abroad.But it can no longer be assumed that services face no international compe- tition.Efficient high-value services will be as important to a nation as the manufacturing of automobiles and electrical equipment once were.2 Since 1959,services prices have increased more than three times as rapidly as industrial prices.This means that many nations will be able to prosper without major manufacturing capabilities. Australia is an interesting example.Still reliant on the production of sheep and raw materials(both related to land),Australia has little or no industrial sector.Its largest export to the United States is meat for hamburgers.On the other hand,its service industries of media, finance,and telecommunications-represented most notably by the media magnate Rupert Murdoch-are the envy of the world.Canada represents a similar amalgam of raw materials and powerful service in- dustries in newspapers,broadcast media,and telecommunications. As a result of these trends,the world may increasingly become di- vided into“head”and“body'”nations,,or nations representing some combination of those two functions.While Australia and Canada stress the headquarters or head functions,China will be the 2ist-century model of a body nation.Although China does not innately or im- mediately know what to produce for the world market,it has found success in joint ventures with foreign corporations.China will be an attractive place to produce manufactured goods,but only because so- phisticated enterprises from other countries design,market,and finance the products China makes.At present China cannot chart its own industrial future. 2See Jose Ripoll,"The Future of Trade in International Services,"Center for Interna- tional Relations Working Paper,UCLA,January 1996. FOREIGN AFFAIRS July/August 1996 [53] Copyright 2001.All Rights Reseved
Richard Rosecrance Neither can Russia.Focusing on the products of land,the Russians are still prisoners of territorial fetishism.Their commercial laws do not yet permit the delicate and sophisticated arrangements that en- sure that"body"manufacturers deliver quality goods for their foreign "head."Russia's transportation network is also primitive.These, however,are temporary obstacles.In time Russia,with China and India,will serve as an important locus of the world's production plant. THE VESTIGES OF SERFDOM THE WoRLD Is embarked on a progressive emancipation from land as a determinant of production and power.For the Third World,the past unchangeable strictures of comparative advantage can be over- come through the acquisition of a highly trained labor force.Africa and Latin America may not have to rely on the exporting of raw ma- terials or agricultural products;through education,they can capitalize on an educated labor force,as India has in Bangalore and Ireland in Dublin.Investing in human capital can substitute for trying to fore- see the vagaries of the commodities markets and avoid the constant threat of overproduction.Meanwhile,land continues to decline in value.Recent studies of 18o countries show that as population density rises,per capita GDP falls.In a new study,economist Deepak Lal notes that investment as well as growth is inversely related to land holdings.3 These findings are a dramatic reversal of past theories of power in international politics.In the 193os the standard international rela- tions textbook would have ranked the great powers in terms of key natural resources:oil,iron ore,coal,bauxite,copper,tungsten,and manganese.Analysts presumed that the state with the largest stock of raw materials and goods derived from land would prevail.CIA es- timates during the Cold War were based on such conclusions.It turns out,however,that the most prosperous countries often have a negli- gible endowment of natural resources.For instance,Japan has shut down its coal industry and has no iron ore,bauxite,or oil.Except for Daniel Garstka,"Land and Economic Prowess"(unpublished mimeograph),UcLA, 1995;Deepak Lal,"Factor Endowments,Culture and Politics:On Economic Perfor- mance in the Long Run"(unpublished mimeograph),UcLA,1996. [54] FOREIGN AFFAIRS Volume 75 No.4
