What makes a sovereign state?

First, there is a territory. The territory has inhabitants. The territory is governed by a state. The state is legitimate.

What makes a state "legitimate"? I think there are two distinct but related criteria, which I'll call internal and external legitimacy. About a year ago, I described what I now think of as internal legitimacy:

Legitimacy sounds very subjective, almost populist. Is a state “legitimate” because the masses agree with it, because people like it? No. It’s nice when they do, maybe even helpful, but nice isn’t what we’re after.

We measure the legitimacy of a state by whether those on its territory both conform to it and resort to it. When the state commands, in the civilized tone of some legal notice (the threat of violence echoing faintly from the pages), do citizens obey? Or do various factions succeed at resisting, ignoring, and defying its edicts? When residents enter into dispute, do they draw their own weapons, or make use of the state’s courts and legislatures and police? Legitimacy is revealed by how people behave, not by what they say they think.

External legitimacy, I think, is even simpler. A state is externally legitimate if it has effective control over violence that projects outward from its borders. If there are marauders or militias that ravage neighboring territories without the state's direction and consent, then the state lacks external legitimacy.

When a state lacks external legitimacy, neighboring states cannot rely upon negotiation to address threats to their interests or to their own legitimacy. Sovereignty is a status that derives from reciprocality among peers. A state that cannot direct or suppress violence from its borders — violations of the sovereignty of neighbors — is not a peer at all. If a state is incapable of respecting neighbors' sovereignty, the state commands no sovereignty for its neighbors to respect.

Finally there is formal recognition. States, and interstate bodies like the United Nations, proclaim by various procedures their recognition that a sovereign state exists, and include those states in ceremonies and institutions reserved for peer sovereigns. The United Nations offers a seat in the General Assembly. Diplomats are dispatched to, and accepted from, the formally recognized state. Among most states, a consensus emerges to describe a community of widely recognized states, which includes most states.

A fully sovereign state demands that all of these criteria are met. The state genuinely governs its territory, suppresses — or in war directs — any violence that might project from its borders, recognizes and is recognized by other, peer, sovereign states.

Of course these criteria are never perfectly met. Every state includes some parties who prosecute disputes via freelance violence ("crime"), even somewhat institutionalized freelance violence ("organized crime"). No state can entirely prevent odd cases of residents traveling from its borders and pulling a gun or attempting some adventure or coup. Any given state may not be formally recognized by some one or few other states. None of these blemishes undo state sovereignty, as long as they are small, idiosyncratic, marginal. It's a judgment call, but it's not usually in practice a hard judgment call. We are usually able to distinguish weirdoes who commit random crimes from organized militias that consistently prepare for and perform violence beyond the capacity of the putative state to control.

The excellent Samantha Hancox-Li writes:

Human history is a river of blood. There is no justice for the numberless dead. Justice is for the living and the yet to be born. It is our responsibility to give not vengeance but peace to those who will come after us. The lesson of history is that it does not matter where you draw the lines on the map. What matters is what kind of society lies on each side of that line. Liberal democracy is the only thing yet discovered that offers a chance for climbing out of the bloody river. Until Palestinians and Israelis both choose liberal democracy, there will be no peace. I do not know how to get there. I only know it is where we must go.

Although I too prefer liberal democracy, I think Hancox-Li sets her ambitions too high, her requirements too stringently. We have had more peace in the world, remarkably, than can be explained by liberal democracy. Saudi Arabia and Egypt are not invading their neighbors, at least not when their neighbors are sovereign states by the three criteria above. (Yemen, in civil war or partial occupation by an Iranian proxy, has not met those criteria for some time.) Iraq in 1990 and Russia in 2014 are exceptions that prove the rule. Invasion of fully sovereign states by fully sovereign states are rare, big-fucking-deals that other sovereign states can be organized to oppose and reverse. Failure to organize and reverse, or at least severely punish, these norm violations invites further catastrophe.

For any sovereign state, a war whose battlefield will include its own territory is terrible. For autocrats as much as for democrats, it is the ultimate negative-sum game. Sovereign states can negotiate and be negotiated with. They can join alliances. Understandings between states can be meaningful and effective. Sovereign states act and can be deterred "rationally", whatever their form of government. After the paroxysms of the mid-20th Century, war between sovereign states became infrequent. We did in fact learn something.

In the vast majority of cases, war comes when the criteria set out above are not met. Violence emerges when a government claims sovereignty over territories beyond its internal legitimacy, beyond its capacity to control external violence, or where the boundaries of the territory are not widely agreed.

Neither Israel/Palestine nor Lebanon are sovereign states. It matters not a whit that they have seats at the UN or internationally recognized borders. It matters even less that Israel refers to itself, absurdly, as a liberal democracy. Israel/Palestine, Lebanon, Syria, post-Saddam Iraq, none of these meet the basic preconditions of sovereign states. So these places are riven by violence, internally among groups that do not recognize the same sovereigns, externally as no sovereign can credibly negotiate terms to suppress the projection of violence into neighboring territories.

The United States, but also China, all the powers and places in the world that enjoy the fruits of peaceful modernity, share a core foreign policy interest in a Westphalian order, in a world be organized into sovereign states that are legitimate internally and externally and widely recognized with clearly demarcated borders. Sovereign states are frequently tempted to undermine the sovereignty of neighbors and rivals, but it's like burning carbon. In the long term, it can only make you better off if everybody else sustains globally the system that you are undermining locally.

Supporting and reinforcing a Westphalian order is a relatively modest ask, compared to universalizing liberal democracy. It's a project the world's great powers and most states might agree upon. It doesn't foreclose geopolitical competition. The world remains a chessboard. But a chessboard has squares.

Last Weekend Adam Ozimek and the Economic Innovation Group hosted an "Econtwitter IRL" meetup at Decades in Lancaster, PA, a wonderful venue Ozimek cofounded. I'm isolated these days. I am very grateful to Ozimek for bringing together an online community I really value but that usually feels distant.

During that event, Cardiff Garcia did a fascinating interview with Paul Krugman, at the end of which Joe Wiesenthal asked a critical question. The United States, under Joe Biden, is embarking on an aggressive program of industrial policy even as it pursues increasingly vigorous antitrust enforcement. Aren't there tensions between these goals? Responding to an antitrust investigation of NVIDIA, Dylan Matthews similarly asked, "Here you have a tremendously successful national champion in a strategically critical industry. Is that exactly what you want[?]"

It's a good question!

South Korea, an industrial policy success story, famously elevated a small number of "chaebols", who dominate that economy to this day. Japan's successful MITI gave the world automobile champions like Toyota and industrial conglomerates like Yamaha. Smaller countries may have no other choice than to endow national champions, boulders among pebbles in their domestic economies, in order to achieve technical economies of scale necessary to compete in world markets.

But industrial policy often fails, and usually when it fails, it does so for simple reasons of political economy. All industrial policy requires that the state subsidize firms, one way or another. But successful industrial policy demands that states also force firms to compete, so the subsidy becomes invested in efficient production, rather than simply captured by shareholders. Here's Vivek Chibber:

In country after country after country, you found [firms] hanging on to the subsidies and the general import-substitution long after everyone realized, ‘Look, we've reached about as far as we can go with the subsidy side, now we need to push these guys into competition.’ Long after they understood that, they stuck with a self-defeating policy.

The question is, why? And the answer is political. Basically, it's this: what all the economists assumed was a government and a state that's essentially free...and powerful enough...to tell firms to do whatever it wants them to do, and they're going to step into line. But the fact is, in any modern industrial capitalist economy, these firms who you're trying to push into exports are also the people with the most political power, the most political influence. They have the lobbyists, they have all the money, they fund elections, and they run the economy.

So here's the trap you were in. You gave them a bunch of free money and now you are asking to give up that free money and go into essentially shark infested waters. And country after country, what most of them said was, ‘Nah, we're not going to do it. Actually, we like it just the way it is.’ And, since we fund all the politicians, whoever gets into power, we're going to make sure they keep plowing this money towards us.

A national champion is at best a double-edged sword. It has the resources to become a world-class competitor, if those resources are allocated adroitly rather than captured as cash flow to shareholders. But those same resources enable it to specialize in exploiting market and political power, rather than in any technical facet of production.

Without competition to inform and discipline a "champion" while it is an infant, competing mostly in domestic markets, often under tariff protection, it may have no way even to learn how to excel at world-class production. The skills required to buy the loyalty of politicians, on the other hand, are accessible, reliable, and widely distributed.

The largest economy to succeed at industrial policy is China. What the Chinese example teaches is that, at least for large economies, there is no need to risk capture by national champions. Instead of targeting a few, particular firms for subsidy, one targets a competitive domestic industry, and funds a whole menagerie.

In 2022, China's leading manufacturer of photovoltaic modules produced less than 16% of industry output. The top four manufacturers accounted for less than 60% of production. Brad Setser points out that in China's "capex heavy steel sector…every province has its own local champion". China bestrides the planet like a colossus in both of these industries, but there are no national champions to be found.

China's experience suggests one can use the conditions of funding to affirmatively structure the market in ways that ensure continuing competition, rather than rely solely on after the fact policing by antitrust authorities. China's subsidies come via provincial governments, whose officials require their champions remain local. In the US, firms might simply be forbidden contractually from selling equity or assets to rivals or roll-ups.

However protected the domestic players might be from more advanced foreign competitors, competition in the domestic economy generates innovation and know-how. Despite subsidy, no domestic firm can rest on its laurels.

As competition brings the quality and efficiency of production towards world-market standards, it becomes politically plausible to reduce trade barriers, placing the now adolescent industry in global competition. Reducing tariffs won't destroy jobs at firms that produce competitively. Firms confident they can compete often lobby for open borders, because they gain access to a much larger global market by ceding some access to their own smaller pond.

So, for larger economies, there is no tension between industrial policy and antitrust. On the contrary, they are essential complements. Successful industrial policy requires that subsidized domestic firms vigorously compete.

National champions are a bad idea. Like athletic champions, they inevitably grow old. A vibrant capitalism (like a vibrant political system) depends on older incumbents ceding dominance to upstarts. Productivity growth is a process of small increments as stalwart firms iterate, but also great leaps as dissidents jump ship from staid incumbents and recombine industry know-how in novel, creative, threatening ways. National champions interfere with this process. They prove capable at discouraging rivals. They defend their turf, until their inevitable collapse — this too must pass — means collapse of a whole nation's industry, rather than a passing of the baton.

We require industrial policy. But we should eschew, even dismantle, "national champions".

I don't think a sovereign wealth fund is a thing one can intelligently be "for" or "against", generically. That's like being asked to take a position on chlorine. I'm against chlorine if the proposal is I should breathe it. I'm for chlorine as part of a water purification process. You really do need to be more specific. There are versions of social wealth funds that I'd oppose, others about which I'd be enthusiastic. I did a talk on the subject several years ago, if you have an hour to kill.

I think people focus too much on the asset and benefits side of social wealth fund proposals, and too little on the effects of how the funds might be financed. In an American context, much of the reason to want a social wealth fund is to divert financial flows from where they would otherwise go.

For example, here's Tyler Cowen:

It is true that the expected rate of return of the US stock market is higher than the US government’s borrowing rate. But what matters is the net social increase in investment value, not the nominal returns on the government’s portfolio. If the government buys some of my mutual funds, for instance, and it earns the 7% return that I would otherwise have earned, there is no net increase in social value. On paper, the sovereign wealth fund looks like a big success, but the government has simply issued more debt and redistributed some equity returns away from the citizenry and toward itself.

Cowen elides questions of distribution. Who is this "citizenry"? To whom do equity returns actually go?

While much of the public owns some shares, fully the majority of US stock market wealth, in dollar terms, is owned by the richest 1%. Only 7% is owned by the bottom 90%.

The government "[r]edistribut[ing] equity returns from the citizenry and toward itself" has another name. It's called a tax. It's a tax that falls almost entirely on the rich, but is experienced painlessly, in the form of returns foregone relative to a counterfactual. The rich find themselves with just a bit less opportunity to get richer.

I wrote about precisely the phenomenon Cowen describes in 2018:

A sovereign — er, social — wealth fund is a taxation machine. It is an automatic taxation monster. It takes the miracle of compound growth that capitalists are always on about and turns it into a miracle of compound taxation, effectively taxing wealthier cohorts (those who would otherwise own the SWF assets) an ever increasing share of income year after year without requiring any new legislation, and with minimal distortion of investment behavior.

To see how this works, let’s imagine that we want to simulate the flows of an SWF+UBD. We’ll imagine a very simple scenario. Let’s define a “notional” SWF. The SWF is going to be financed by a tax enacted just once, which will yield $1T in Year 0. The tax take will grow with nominal GDP, which we will model as growing at 5% annually. Beginning at the end of Year 1, the SWF will make payouts. For simplicity, we will base payouts and returns on the end-of-prior-year balance. That is, we are conservatively assuming that the taxes we collect within a year are unavailable until the year following. We will assume a constant rate of investment return of 8% per year. Echoing Bruenig’s proposal, we will have the SWF payout 4% of the prior year balance each year.

However, instead of actually forming the SWF, let’s say that the government were to decide that there’s no need to intervene in the miraculous private sector with actual state ownership, that the assets can remain, um, efficiently managed in private hands but the government will simply use the tax system to reproduce the flows an SWF would generate. As it would if it actually formed the SWF, in Year 0 it would enact a tax, which would raise $1T. At the end of Year 1, it would have raised an additional $1.05T from the same tax. The notional SWF would have enjoyed the same $1.05T as new contribution. However, the notional SWF, if it had actually been constituted, would have also earned $0.08T as investment returns. In order to simulate the SWF flows, the state would have had to adopt a new capital tax of $80B. In Year 2, we have the same effect again. The originally enacted tax now raises $1.1025T, and the new Year 1 tax brings in $84B (assuming that both grow in line with GDP), for a total intake of $1.1865T. However, investment returns on the prior year SWF balance of $2.09T would have yielded $167.2B, which when added to the same take of $1.1025T from the initial tax, yields an inflow of $1.2697T. So, to bring the total inflows in line with what an SWF would have done automatically, the government would have to impose a new tax of $83.2B.

And so on. Each year, to reproduce the same net flows from private capital holders as would “naturally” have occurred had there been a SWF, the state would have to enact a brand new tax, in addition to still collecting the taxes enacted in prior years. Under our assumptions, each year’s new tax is slightly smaller as a share of GDP than the prior year’s, but in reality, that would depend upon investment returns, gdp, and dividend payouts. Whenever investment returns net of dividend payouts exceed GDP growth, the effective new tax that would need to be imposed on capital holders becomes larger as a share of GDP than the prior year’s tax. (Here’s the little Mathematica simulation the numbers in this section are drawn from: [pdf][nb])

We can all, as Mike Konczal put it on Twitter, “spitball” about politics. But I think it fair to say that it would be difficult to sustain the political will to cumulatively impose new taxes on capital holders, every year, year after year after year over a period that might span decades. But the “gimmick” of actually using the proceeds from a single tax, enacted once and continued indefinitely, to purchase capital assets, generates the same effect as this compounding tax schedule in a way that seems natural and inevitable and legitimate under the norms of present-day capitalism. If we accept that other capital holders get to enjoy the miracle of compound returns, why shouldn’t a fund owned in equal shares by all citizens get to enjoy the same? Actually constituting a SWF delivers a regime of effective taxation that, I think it is fair to say, ordinary politics simply could not.

If you think it is a good thing to let the "miracle of compound growth" cumulate endlessly in wealthy private hands — creating permanent, ever-expanding gaps between the rich and the less rich, entrenching a system of wealth-stratified caste — then yes, you should oppose the state "[r]edistribut[ing] equity returns from the citizenry and toward itself".

If, however, you think letting compound growth continually expand the advantage of the already wealthy is not great, if you dislike living in a society whose economic, political, and cultural life is increasingly vandalized and held for ransom by mad billionaires, then perhaps it would desirable to divert equity returns away from "the citizenry" and towards purposes whose benefits will be much more widely shared.

The state, of course, is corrupt as fuck. But in its worst corruption, nothing that the state does at scale results in benefits as lopsidedly plutocratic as the dollar distribution of investment returns when they compound in private hands.