In an interview with The Cipher Brief last month, former Deputy CIA Director Michael Morell said that one of the things he would tell the next president is that “the health of a nation’s economy is the single most important determinant in its ability to protect itself, the single most important determinant in its ability to project power, the single most important determinant in its national security.”
What many of our readers may not know is that Morell started his 33-year career at CIA as an economic analyst before rising through the ranks to become Deputy Director and twice Acting Director, that he worked on some of the most interesting economic issues of the past three decades—the rise of the Asian Tigers, the rise and then stagnation of Japan, the rise of China, and multiple financial crises from Mexico to Asia.
With that in mind, we asked Morell to provide some of his insights on global economic trends and their implications for national security.
The Cipher Brief: Before turning to the world, do you have any thoughts on the US economy, given its important role as a driver for the world economy? There are some who are concerned about a near-term recession.
Mike Morell: A CIA analyst would not comment on the US economy. The Agency’s focus is overseas, appropriately so. But since I am no longer a CIA officer, let me say a couple of things.
First, we have a growth problem. Over the past 25 years, inflation-adjusted GDP in the U.S. has grown at an average annual rate of 2.5 percent. That is not great – below the potential of the economy that leads the world in technological innovation and entrepreneurship. The growth problem has become even worse since the end of the 2008 financial crisis, with average annual growth of only 2.3 percent – well below what growth has been during previous recoveries. The recovery has certainly been steady, but it has not been strong.
And, unless something changes, the picture could become acute – even slower growth, maybe a recession. We tend to look at the demand side of the economy, but it is equally important to look at the supply side. Both Martin Feldstein and Larry Summers have pointed out that the vast majority of the growth in inflation-adjusted GDP since the end of the financial crisis has been due to the increase in employment – that is, has been due to the increase in production from simply putting people back to work, from lowering the unemployment rate from 10 percent to 5 percent. Very little of the post-recession growth has been due to increased capital spending or increased productivity. So, with not a lot of room to further push down the unemployment rate, even the slow growth of the last six years will not be sustainable, unless something changes on the capital or productivity side. That’s a big deal for the economy and that’s a big deal for whoever the next president turns out to be. We have to get capital off the sidelines and into the game.
And, second, we have an income inequality problem. Income distribution in the U.S. is now among the worst in the developed world – with incomes at the low end of the spectrum actually falling and incomes at the high end rising rapidly. The distribution of income in the U.S. today looks a lot like it did in the 1920s — a dramatic change from where we were in the 1950s through the 1970s. Here is what is happening from an economist’s point of view — there is excess demand for highly skilled workers (not enough of them) and an excess supply of low-skilled workers (too many of them). There are some 20 million people either unemployed or underemployed, most of them unskilled. There are some four million jobs that are unfilled, for mostly skilled workers. This is why incomes are rising for skilled workers and falling for the unskilled. Lots of reasons for this, of course, but a key one, I think, is that our education system has not kept up with advances in technology and globalization. Technology and globalization have increased the demand for skilled workers and reduced it for unskilled, and the education system has not shifted the skill composition of workforce fast enough to keep pace. It’s time, in my view, for major investments in education – particularly at the younger grades, where economists say that a dollar invested earns the most return for the competitiveness of the economy.
TCB: So, what is the implication of all this?
MM: The growth issue has all sorts of significant implications, but for our purposes, let’s focus on national security. The key reason that China has been able to significantly grow the size and capability of its military over the past 20 years is because of the growth of its economy. If we could raise the growth of our GDP by just one percentage point a year for 20 years, our military would be almost a quarter larger than it would be otherwise (if we keep defense spending at constant share of the economy). That’s a huge difference, of course. You will remember that the link between economic growth and military power was the key one identified by Paul Kennedy in his now classic book, The Rise and Fall of Great Powers. This is what I meant when I said the words I did in our last interview about the importance of the economy to national security.
Growing income inequality creates long-term economic problems, but perhaps most seriously, it creates political problems that could, in turn, become even bigger economic problems. That is playing out in front of us right now. The people on the losing end of the income story are using the voting booth to express their frustration and anger, and they are running to candidates who are endorsing populist policies – income redistribution, restrictions on trade, etc. The problem is that, if implemented, these policies would actually undermine the long-term health of the economy. They would make matters worse.
TCB: Let’s turn our attention overseas. At a time when China and Russia have become more militarily assertive, both are experiencing economic difficulties at home. Turning to China first, the world’s second largest economy behind the U.S., what do you see as the key factors contributing to China’s slowing growth?
MM: I think that the Chinese economy faces numerous and significant headwinds. The list includes a declining labor force, breathtaking over-capacity in a wide range of industries (in the steel industry, for example, there is 400 million tons of over capacity – a quarter of world demand), high-debt levels, little productivity growth, serious environmental degradation, corruption, financial bubbles, and on and on.
China watchers talk about two scenarios – a soft landing and hard landing for the economy. A soft landing is growth that settles in the 5-7 percent range over the next 10-15 years. A hard landing is a deep recession followed by growth of no more than 2 percent over a long period of time.
TCB: What is the role of the Chinese government here? And, what are the implications of the various scenarios for stability in China, the region, and the world?
MM: The Chinese government is actually the key to which scenario emerges, to whether we get a soft landing or a hard one. A soft landing requires a set of economic reforms – from reorienting the economy from export-led growth to domestic-demand led growth, establishing functioning markets for allocating capital, reducing the role of state-owned enterprises, etc. President Xi Jinping knows this. He knows what needs to be done. The Communist Party leadership two years ago said very clearly it would move ahead with reforms. The problem, however, is that some of the economic reforms that are needed could undercut the Communist Party, so we shall see how far Beijing goes with reform. The current boom in the service sector will give the government some time to get the reforms in place but not an infinite amount of time.
How all of this plays out, of course, is of great significance. A new wave of economic reform with the soft landing it would create would be good for China and would be good for the world. Everyone would benefit. A hard landing would, of course, act as a drag on the world economy. But even more concerning is how a hard landing would play out domestically in China. The implicit deal between the Chinese government and its people has always been that the government deliver’s economic growth and the public accepts the Party’s continuing monopoly of power. What happens if the government stops delivering growth? In that case, I would become very concerned about stability in the world’s most populous countries.
TCB: Turning to Russia, how do you read economic trends in Russia and do they matter as much as China?
MM: Russia’s economy faces both near-term headwinds and long-term ones. The historically low oil prices of today have been extremely painful for an economy that has over-invested in oil and gas. Western sanctions that have resulted from President Vladimir Putin’s behavior in Ukraine have also damaged the economy. Longer-term, the demographics of Russia – a very rapidly shrinking labor force – and a lack of integration with the West suggest, I think, a long-term degradation of the economy.
TCB: What are the implications of this for Russia, the region, and globally?
MM: Some of Russia’s economic problems are the result of Putin’s malign behavior. Ironically, the big loser from what Putin did in Ukraine is Russia; the Russian economy, the Russian middle class. So, simple logic would tell you that growing economic pressures might well lead to a change in that behavior. But, I am not so sure. The two most important things to Putin are one, Russia being seen as a great power in the world, on an equal footing with the US, and two, Russia having significant influence in the countries on Russia’s periphery. These are legacy issues for him, and he has shown that he is willing to pay a considerable economic price to pursue them. I don’t see that changing as long as he is in office. (By the way, the first legacy issue – being seen as a great power – is one of the key reasons Putin is doing what he is doing in Syria, and the second legacy issue is the main reason he is doing what he is in Ukraine).
Over time, I think that Russia’s economic problems will mean that the country has fewer resources to play on the world stage, fewer resources to behave badly (or to do good). In fact, it is likely that Russia will become just the opposite of what Putin wants – a weak state. And, while there may well be less danger from Russia at the end of the journey, the danger may actually be higher during the transition. This is because, as the bad economic news builds in Russia, so will the political pressures on Putin. In that kind of environment, Putin will have greater incentive to intervene overseas (even in the face of fewer resources) in order to redirect the country’s attention from the economy.
TCB: Low oil prices are also affecting the economies of strategic countries in the Middle East, most significantly, Saudi Arabia. What are the challenges for Riyadh, and how will they potentially effect stability in the region?
MM: I’m less concerned than some about the potential impact of low oil prices on Saudi stability. I actually think that the current situation in the oil market may well turn out to be a blessing in disguise for Riyadh, because it is forcing the Kingdom to consider reforms that will strengthen the government’s long-term fiscal situation and that will diversify the economy. The Deputy Crown Prince, Muhammad bin Salman, is already putting together an economic plan that, I think, will be viewed very positively by most economists and, most importantly, by western companies. I think it could well be a blueprint for the Kingdom’s economic future.
TCB: One last question: What was it like being an economic analyst at the Agency? What was the coolest thing you ever did as an economic analyst?
MM: It was great. I worked on important issues. Looking back on it, I think one could put my work in two different bins. The first was traditional economic analysis – for example, how much would Japanese imports rise if Japanese trade barriers were eliminated, how dependent would Western Europe be on Soviet natural gas if the Russians built two gas pipelines to the west. The second bin was using economic analysis tools on non-economic problems – for example, modeling the degree of fraud in the 2006 Philippine election between Marcos and Aquino.
Something cool? Well, let’s see, an operations officer once took me to a meeting with a spy. No kidding. Such an experience is very unusual for an analyst. The meeting was in a restaurant overseas. The spy had a newspaper with documents in it. We had a newspaper with more questions for the spy. The two newspapers were on the table. After a few minutes of small talk, the spy got up and left – taking our newspaper and leaving his. How cool is that?