In September 1997, Malaysia's Prime Minister, Dr. Mahathir Mohamad, used the World Bank meeting in Hong Kong to denounce the evils of globalization, after Malaysia's stocks and currency were ravaged by global and local investors. Mahathir blasted "morons" who trade in currencies, and he accused the "Great Powers" and financiers such as George Soros of forcing Asians to open their domestic markets to global speculators and manipulating their currencies to destroy them as competitors. He compared today's global capital markets to "a jungle of ferocious beasts," and implied that they were directed by a Jewish cabal. Listening to Mahathir's rant, I tried to imagine what then-U.S. Treasury Secretary Robert Rubin, who was in the audience, would have said to the Malaysian leader had he really been able to speak his mind. I think it would have been something like this:

"Ah, excuse me, Mahathir, but what planet are you living on? You talk about participating in globalization as if it were a choice you had. Globalization isn't a choice. It's a reality. There is just one global market today, and the only way you can grow at the speed your people want to grow is by tapping into the global stock and bond markets, by seeking out multinationals to invest in your country and by selling into the global trading system what your factories produce. And the most basic truth about globalization is this: No one is in charge-not George Soros, not 'Great Powers' and not I. I didn't start globalization. I can't stop it and neither can you-except at a huge cost to your society and its prospects for growth. You keep looking for someone to complain to, someone to

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take the heat off your markets, someone to blame. Well, guess what, Mahathir, there's no one on the other end of the phone! I know that's hard to accept. It's like telling people there's no God. We all want to believe that someone is in charge and responsible. But the global market- place today is an Electronic Herd of often anonymous stock, bond and currency traders and multinational investors, connected by screens and networks. And, Mahathir, don't you play dumb with me. We both know your Central Bank lost 3 billion dollars speculating on the British pound in the early 1990s-so don't give me that innocence crap. The Electronic Herd cuts no one any slack. No one. It does not recognize anyone's unique circumstances. The herd knows only its own rules. But the rules of the herd are pretty consistent-they're the rules of the Golden Strait-jacket. Now, the herd feeds in 180 countries, Mahathir, so it doesn't have time to look at you in detail all the time. It makes snap judgments about whether you are living by its rules, and it rewards most lavishly those countries that are transparent about what they are doing. The herd hates surprises. For years Malaysia seemed to be living by those rules, and it attracted massive amounts of direct investment and portfolio investment, which enabled you to raise your per-capita income from 350 dollars to 5,000 dollars in a couple of decades. But when you started to break the rules by over-borrowing and then overbuilding, well, the herd sold you out. Did you really need to build the two tallest office buildings in the world? Have you rented even half their office space? I hear not. So the herd stampeded you and left you as roadkill. The KLCI Index, your Dow Jones, fell forty-eight percent in 1997, and your currency hit a twenty-six-year low. But when that happens you don't ask the herd for mercy, you don't denounce the herd as a 'Jewish Conspiracy,' you just get up, dust yourself off, put your Golden Straitjacket on a little tighter and get back with the flow of the herd. Sure, this is unfair. In some ways the herd lured you into this problem: It kept offering you all this cheap money and you took it and then overbuilt your dams, your factory capacity and your office towers. But that's what's really scary, Mahathir: The herd is not infallible. It makes mistakes too. It overreacts and it overshoots. But if your fundamentals are basically sound, the herd will eventually recognize this and come back. The herd is never stupid for too long. In the end, it always responds to good governance and good economic management. Hey, America had similar fluctuations when it was an emerging market,

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with our railroad busts and booms. You just have to manage them and build in as many shock absorbers as possible. I track the herd's movements all day on the Bloomberg screen next to my desk. Democracies vote about a government's policies once every two or four years. But the Electronic Herd votes every minute of every hour of every day. Anytime you want to know, the herd will tell you exactly how you look in a Golden Straitjacket and whether it fits well or not. I know you think that I'm the all-powerful U.S. treasury secretary. But, Mahathir, I live just like you-in terror of the Electronic Herd. Those idiots in the media keep putting me on the front page, as if I'm actually in charge, and I'm sitting here terrified that if our Congress refuses to grant the president authority to expand free trade, or busts the budget ceiling, the herd is going to turn against me and trample the dollar and the Dow. So let me tell you a little secret, Mahathir-and don't tell anyone else. I don't even keep a phone on my desk anymore, because I know better than anyone: There's nobody to call."

Like it or not, my imaginary treasury secretary is basically talking the truth. Countries cannot thrive in today's world without plugging into the Electronic Herd, and they cannot survive unless they learn how to get the best out of this herd without being overwhelmed or shocked by its inevitable surges. The Electronic Herd is just like a high-voltage wire that comes into your house. In normal times it can warm you, light your home and provide many of your energy needs. But if you don't have the right electricity regulators and surge protectors, and there is a sudden power surge or drop, it can shock you, fry you to a crisp and leave you for dead.

The Electronic Herd today consists of two basic groups. One group I call the "short-horn cattle." This includes all those people involved in the buying and selling of stocks, bonds and currencies around the world, and who can and often do move their money around on a very short-term basis. The short-horn cattle are currency traders, major mutual and pension funds, hedge funds, insurance companies, bank trading rooms and individual investors. They include everyone from Merrill Lynch to Credit Suisse to Fuji Bank to the Charles Schwab Web site, where anyone with a PC and a modem can trade on line from his living room.

The other group I call the "long-horn cattle." These are the multinationals-the General Electrics, the General Motorses, the IBMs, the

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Intels, the Siemenses-which are increasingly involved in foreign direct investment, building factories around the world or striking international long-term production deals or alliances with overseas factories to make or assemble their products. I call them the long-horn cattle because they have to make longer-term commitments when they invest in a country. But even they now move in and out, like a herd, with surprising speed.

Though the Electronic Herd was born and nurtured in the Cold War era, its members could never gather the critical mass, speed or reach in that overly regulated, walled-up system. Most countries maintained capital controls (at least until the 1970s), so capital could not move across borders the way it can in today's globalization system. This made it much harder to get a global herd together. In the relatively closed economies of the pre-1970s Cold War system, a government's own monetary policy completely dominated the setting of its own interest rates and a government's own fiscal policy was far and away the dominant instrument for stimulating growth. Also during the Cold War, the U.S. and Soviet governments could easily justify the high taxes needed for fiscal policy by invoking the Cold War: "We need your tax dollars to fight the enemy, put a man on the moon first and build a new highway system so we can move our army around faster." At the same time, many developing countries could muddle through by milking one of the super- powers-namely, the United States, the Soviet Union or China-{)r international lending institutions to fund a dam, support an army or build a highway. And because the citizens of these developing countries were not nearly as aware as they are today of how everyone else in the world was living, they were ready to tolerate the lower living standards that come from having a relatively closed economy.

But with the gradual lifting of capital controls in the 1970s, the democratizations of finance, technology and information, the end of the Cold War system and the fall of walls everywhere, there suddenly emerged a vast global plain where investor herds from many different countries could roam freely. It was on this wide-open plain, later expanded into cyberspace, that the Electronic Herd could really graze, grow, multiply and eventually gather in powerful Supermarkets. By the late twentieth century the dominant fact of the global financial system was that the private sector-what I call the Electronic Herd and the Supermarkets-had become, as U.S. Treasury Secretary Larry Summers

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once put it, "the overwhelming source of capital for growth," replacing the public sector. This has been true both within countries and between the developed countries and developing countries. According to the U.S. Treasury, in the 1990s nearly $1.3 trillion in private capital has flowed to the emerging market economies, compared to roughly $170 billion in the 1980s and a relative pittance in the 1970s. There is no better indicator for the way in which the Supermarkets have replaced the superpowers as sources of capital for growth.

The Supermarkets are the megamarkets of Tokyo, Frankfurt, Sydney, Singapore, Shanghai, Hong Kong, Bombay, Sao Paulo, Paris, Zurich, Chicago, London and New York. They are where the biggest members of the Electronic Herd come together, exchange information, execute their trades and issue stocks and bonds for different companies for the herd to feed upon. According to University of Chicago globalization expert Saskia Sassen, by the end of 1997 twenty-five Supermarkets controlled 83 percent of the world's equities under institutional management and accounted for roughly half of global market capitalization-around $20.9 trillion (Foreign Affairs, Jan. 1999).

This Electronic Herd-and the Supermarkets where it gathers to feed and procreate-have become important international actors in the globalization system; While they cannot go to war or invade a country, like nation-states, they are able to shape the behavior of nation-states in many areas. And that is why I contend that while the Cold War system was a system based on a balance between states, the globalization system is based on a balance between states and other states, and between states and the Electronic Herd and Supermarkets. Ever since the invention of the transatlantic cable, in the pre-World War I era of globalization, some sort of Electronic Herd has been at work, but during the Cold War system it was never as important as it is today. What is new about today's herd is not so much a difference in kind as in degree. Because of globalization, today's Electronic Herd-both its short-horn cattle and its long-horn cattle-combines size, speed and diversity to a degree never seen before in history. A mouse has a tail and a Tyrannosaurus Rex has a tail. They are both called "tails," but when one swings it has a very different effect on the world around it than the other. The Electronic Herd in the first era of globalization was like the tail of a mouse. Today's Electronic Herd is like the tail of a Tyrannosaurus Rex, and when it swings it reshapes the world

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around it in some fundamental ways. This chapter explains how this herd has become such an irresistible source for economic growth and, at the same time, such an intimidating force that it can even topple governments when it swings.

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What does all this have to do with globalization? Let me try to answer by using some simple analogies from the world of computers. I like to compare countries to three parts of a computer. First, there is the actual machine, the "hardware." This is the basic shell around your economy. And throughout the Cold War system you had three kinds of hardware in the world-free-market hardware, communist hardware and hybrid hardware that combined features of both.

The second part is the "operating system" for your hardware. I com- pare this to the broad macroeconomic policies of any country. In the communist countries the basic economic operating system was central planning. There was no free market. The government decided how capital should be allocated. I call that communist economic operating system DOScapital 0.0.

In the hybrid states the operating systems were various combinations of socialism, free markets, state-directed economics and crony capitalism, in which government bureaucrats, businesses and banks were all tied in with one another. I call this DOScapital 1.0 to 4.0, depending on the degree of government involvement and the sophistication of the economy. Hungary, for instance, is DOScapital 1.0, China is DOScapital 1.0 in the hinterland and 4.0 in Shanghai, Thailand is DOScapital 3.0, Indonesia is DOScapital 3.0, and Korea is DOScapital 4.0.

Last come the big industrial capitalist systems. Some of these have operating systems that are based on free markets but still have significant welfare-state components. This group includes France, Germany and Japan, and I call their operating systems DOScapital 5.0. Others, though, such as the United States, Hong Kong, Taiwan and the United Kingdom, have liberalized their economies and have put on the full Golden Strait-jacket. They have DOScapital 6.0.

In addition to the type of hardware enclosing an economy and its basic operating system, there is also the "software" it needs to get the most out of both. Software, for me, are all the things that fall broadly in the category of the rule of law. Software is a measure of the quality of a

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country's legal and regulatory systems, and the degree to which its officials, bureaucrats and citizens understand its laws, embrace them and know how to make them work. Good software includes banking laws, commercial laws, bankruptcy rules, contract laws, business codes of conduct, a genuinely independent central bank, property rights that encourage risk-taking, processes for judicial review, international accounting standards, commercial courts, regulatory oversight agencies backed up by an impartial judiciary, laws against conflicts of interest and insider trading by government officials, and officials and citizens ready to implement these rules in a reasonably consistent manner.

In the Cold War, the big struggle was over whose hardware would dominate the world. The Soviets and Americans didn't pay all that much attention to how well their hardware was actually working in any particular allied country. They just wanted to make sure that other countries were using their brand, with their stickers. Indeed, a country could get by for a long time with a terrible operating system inside, and corrupted software, because the Soviets and Americans were so anxious to have it on their team, they would just subsidize it or offer free repairs-as long as that country stuck with the superpower's brand. Both superpowers lived in fear of the "domino theory," which stated that if a certain key country would change hardware, all its neighbors would change too.

This struggle ended with the collapse of the Cold War system. Suddenly, the communist, socialist and even hybrid models were all discredited. Suddenly, we found ourselves at a remarkable moment in history: For the first time, virtually every country in the world had the same basic hardware-free-market capitalism. Once that happened, the whole game changed. Countries no longer had to decide which hardware to choose, just how to make the best of the only hardware that seemed to work - free-market capitalism.

But there is a saying in the world of computer technology: "The hardware always runs ahead of the software and the operating systems." That is, the engineers keep inventing faster and faster chips and only later do the operating systems and the more sophisticated software get developed to really take advantage of this new hardware and get the most out of it. This dictum also applies to the world of globalization. What the world has witnessed since the collapse of communism and socialism in Russia, Eastern Europe and the Third World is a large number of countries adopting

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the basic hardware of free markets, and even plugging their hardware into the high-voltage Electronic Herd, but often without the operating system, software and other institutions needed to effectively manage and rationally allocate the currents of capital and energy that can flow in and out once a country is connected to that herd.

This, we are discovering, is one of the central problems in the transition from the Cold War system to the globalization system: the problem of "premature globalization." I repeat: You cannot thrive today without plugging into the Electronic Herd and the Supermarkets, and you cannot survive today unless you have an operating system and software that will allow you to get the most out of them and protect you from their worst excesses when they stampede.

It was inevitable that as everyone moved to the same brand of hardware-free markets-there would be lags in how different countries developed their operating systems and the software to catch up. Hey, it's easy to buy a computer, especially when there is only one brand. Any moron can go out to Computer City and pick one up. And in the transition from the Cold War system to the globalization system many countries did just that, without ever thinking about whether they had the operating system and software to. effectively operate that computer. These countries just said, "Hey, this looks easy. I'll' just plug my dandy new hardware into this Electronic Herd right here. . ."

But it was actually much harder than it looked. It's easy to declare a free market in your country. What's difficult is to establish evenhanded enforcement of equitable laws and commercial codes, with courts that protect people from unfettered capitalism. It's easy to open a stock market. Even Mongolia has a stock market today. But it's very difficult to build a Securities and Exchange Commission (SEC) that can control insider trading. It's easy to suddenly loosen the reins on the press and permit the free flow of economic information. But it's very difficult to establish and protect a truly independent free press that will expose corruption inside government and unmask flimflam companies that are cheating their shareholders.

This process of building software and operating systems is emerging as the weak link in the globalization chain. That is, we now know that globalization or commerce, trade and economic development leads to more prosperity for more

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people; and more prosperity tends to lead to more pluralism and political liberalization; and greater liberalization leads to democratization. But for this chain reaction to get going your country needs to get its basic operating system and software in place, and taking this first step often clashes with a country's culture, history and imbedded institutions or the lack of them. Therefore, this first step turns out to be much more difficult than originally thought in the euphoria that followed the fall of the Berlin Wall.

Think about Poland and the Soviet Union. They emerged from the Cold War at roughly the same time. Both initially experienced economic downturns, Poland soon started growing, though, but Russia didn't. The reason was partly due to the fact that Poland, which had a history of capitalism before the communists took over, was able to put in place relatively quickly a lot of the basic software and operating systems needed to succeed in the globalization era. But Russia, with no history of capital- ism or democracy, has had a much harder time, and paid the price. I always remember a joke that Secretary of State James A. Baker III told reporters traveling with him-a joke that Soviet President Mikhail Gorbachev told him. Gorbachev was trying to underscore to Baker how difficult it was for Russia to make the psychological transition to capitalism, after so many years of communism, and he did it with this yarn: A Russian peasant finds a lamp by the side of the road and rubs it. Out pops a genie. The genie tells the peasant he can have any wish.

The peasant tells the genie, "You know, I have only three cows, but my neighbor Igor has ten cows."

"So you want twenty cows?" the genie asks the peasant.

"No," says the peasant, "I want you to kill seven of Igor's cows."

In the Cold War system, the big divide in the world was between communist and capitalist economies, with a few hybrids in between. Now that virtually everyone has the same hardware, the big divide in the world is increasingly going to be between free-market democracies and free-market kleptocracies. Those countries that are able to develop the operating systems and software to go with free markets will move in the direction of free-market democracies. Those countries that are unable, or unwilling, to develop the software and operating systems will move in the direction of free-market kleptocracies, where the state basically gets

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taken over by robber barons and criminal elements, none of whom have I an interest in the real rule of law.

Goodbye, communists versus capitalists. Hello, free-market democrats versus free-market kleptocrats.

Since most people are familiar with what the best free-market democ- racies look like, let me illustrate what the worst free-market kleptocracies look like. Then you can locate any country on the spectrum in between.

The purest form of free-market kleptocracy that I have ever seen was Albania in the 1990s. Albania had been one of the most isolated communist countries for fifty years, having adopted a Maoist, pro-China stance in the Cold War. Following the collapse of the Berlin Wall, the communist regime in Albania also collapsed in 1991. Rudimentary elections were held in Albania, and a quasi-democratic government was established in Tirana. Finally, the Albanians thought, we are getting what everyone else has: free-market hardware. Unfortunately, that's all they got. Albania was all hardware, with no software and no operating system.

While I was visiting Tirana in 1998, Fatos Lubonja, a forty-seven-year-old Albanian writer and editor of the Albanian literary journal Endeavor; described to me what it was like to live in the Albanian kleptocracy. "After communism," he said, "we had total equality here. We were all at zero. Few people had property or contacts. So a hierarchical system only emerged after that. Basically, people looked at politics as a business, because being a politician meant that you could open or close doors. You could give or not give stamps. The free market was considered free to do anything. So the boldest people started doing all sorts of things, and the criminals discovered that they needed politicians for some things and politicians discovered they needed money to stay in power. People had no experience. They were not educated [in government affairs]. They did not realize that without the software, Albania would be a jungle, and so people suffered, and many were kidnapped by gangsters or left the country. [Soon people realized that] Albania could not compete in the free market except with an illegal economy. So we created this criminal bourgeoisie. They don't pay taxes. They are not

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responsible for the social lives of the people or for infrastructure. They just take and take. If you can't compete on microchips you will compete on mafia. As for building a real free-market democracy, we are at zero point. The first five years were just the last mutation of communism. Instead of building a free-market economy that would reward initiative and risk, we created a criminal economy linked with the pyramid schemes. People put their money in these pyramids. And instead of investing they were just drinking coffee and waiting for money to come to them, which is what the pyramid owners promised. This reminded me of how we used to wait for aid from China, and live off that [in the Cold War]. Whatever it was, it was not real economics."

Indeed, what happened in Albania was that instead of a proper banking system, the government tolerated, and to some degree even nurtured, Ponzi schemes-one of the oldest forms of swindle. So well established were these Ponzi schemes in Albania that one of the most brazen of them even sponsored an Italian race-car team, as though it were MasterCard International. The organizer of a typical Ponzi scheme came to people and told them if they would deposit their savings in the "fund" they would earn 20, 30, even 50 percent on their money in six months. Because the Ponzi funds had few if any real investments to earn such high returns on, the way they paid out this high interest was by constantly luring in new investors to payoff old ones-while always skimming a little cash off for the fund managers. It all works fine until you run out of new investors.

"The Ponzi schemes began with efforts to raise cash to finance the purchase of gasoline that could be smuggled at very high prices into neighboring Montenegro and Serbia, which were under international sanctions during the Balkan war," Carlos Elbirt, head of the World Bank office in Tirana, explained to me. "But after the sanctions were lifted on Serbia, there was no real business activity behind the Ponzi schemes, so they just became a business of getting new money to finance old money. When the people running these things were really desperate for new cash, they offered fifty percent interest on your money. It was hard for me to convince even my own Albanian [World Bank] staff that these Ponzi schemes were doomed to fall. My staff would nod their heads at my graphs and then put more money into their Ponzi scheme. They were just too tempting, and everyone was doing it. It was like a fever. People sold

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their homes and put the money in Ponzi schemes and then in two or three months they bought back their old home and a new one. The IMF and the central bank warned the Albanian government, 'Money doesn't grow on trees,' but the government would not step in."

This was in part because the Albanian government did not have enough people who knew better and in part because many of its own officials were caught up in Ponzi fever. "If I went to an ambassador's resi- dence on his country's national day, you would see an owner of the pyramid schemes there," said Elbirt. "They were totally accepted and legitimized, and that is what led a lot of common people to them."

Eventually, though, the Albanian pyramid savings funds collapsed in 1997, as these things always do, leading to a total breakdown of law and order, with furious Albanians ransacking their own state in an effort to

get their money back. Elbirt and other foreign diplomats had to be evacuated for their safety. They drove in a British-organized convoy from Tirana to the port of Durres. Once they got to Durres, the helicopter that was supposed to lift them out couldn't land because there was so much shooting. So the convoy was moved to a different area of the port, which was controlled by the Italians. The diplomats had all been driven to Durres in their official cars with their official drivers, and their drivers were all parked in the port, waiting to take the cars back to Tirana. But anarchy reigned, and a group of half-drunk Albanian thieves set upon the port and began stealing all the cars. Elbirt said the most striking moment came when a thief showed up, took out a "big, big gun," demanded the keys to the car of one of the evacuees and then sped away with it, all in less than a minute. Ten minutes later, though, the thief returned, and demanded all the official registration papers for the car he had just stolen. It was as though the thief had an inkling that just in case Albania ever got some software, he might need the ownership documents.

Said Elbirt: "He was very polite. Once the actual robbery was over, it seems he just wanted 'to make the transaction official."

The story of Albania in the 1990s is an extreme example that proves a simple point: Those people who worried or predicted that, because of globalization and the increasing irrelevance of borders, the nation-state would begin to wither away or diminish in importance are dead

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wrong. In fact, they speak utter nonsense. Because of globalization and the increasing openness of borders, the quality of your state matters more, not less. Let me repeat that a little louder: IN THE GLOBALIZATION SYSTEM YOUR STATE MATTERS MORE, NOT LESS. Because the quality of your state really means the quality of the software and operating system you have to deal with the Electronic Herd. The ability of an economy to withstand the inevitable ups and downs of the herd depends in large part on the quality of its legal system, financial system and economic management-all matters still under the control of governments and bureaucrats. Chile, Taiwan, Hong Kong and Singapore all survived the economic crises of the 1990s so much better than their neighbors because they had better-quality states running better-quality software and operating systems.

Thai Prime Minister Chuan Leekpai told me in early 1998, after his country got battered in the Asian economic crisis: "If you are going to be part of this global market you had better be able to defend yourself from this market. . . One of the lessons this crisis has taught us is that many of our structures and institutions were not ready for this new era. Now we have to adapt ourselves to meet international standards. The whole of society expects it. They are looking for better government and transparent government."

But while the state matters more now, not less, what has changed is what we mean by the state. In the Cold War, it was the size of the state that mattered. You needed a big state to fight the communists, maintain the walls around your country and sustain a generous welfare system to buy off your workers so they wouldn't go communist. In the era of globalization it is the quality of the state that matters. You need a smaller state, because you want the free market to allocate capital, not the slow, bloated government, but you need a better state, a smarter state and a faster state, with bureaucrats that can regulate a free market, without either choking it or letting it get out of control. The trick for governments today is to get the quality of their states up at the same time that they get the size of their states down. One of the most important and enduring competitive advantages that a country can have today is a lean, efficient, honest civil service.

That's why the big issue for many of the former communist and hybrid, state-dominated economies is whether, once they start to get the

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size of their government down (by liberalizing, deregulating and priva- i.ll tizing their state-owned industries) they can also get the quality of their government up. Because less government without better government is really dangerous. You need a balance. You want a state that is strong enough and involved enough to maintain a level and fair playing field, to ensure that the best innovators and entrepreneurs win, but not one that is so strong and so involved that it is either picking winners or protecting losers from winners or protecting losers from internal or external competition. If your market is all stoplights and no freeways, it breeds stagnation. And if your free market is all freeways and no stoplights, it breeds chaos. In the case of Russia and Albania premature globalization, after the collapse of communism, led to all freeways and no stoplights. Russia plugged into the Electronic Herd with virtually no operating system and no software. As a result, Russia had people taking advantage of the privileges of a free market-taking in foreign investments, issuing stocks and bonds, making international loans-without sufficient oversight or taxation to generate incomes to pay the bondholders back. And when the herd finally realized that Russia was nothing more than a piece of free- market hardware with no operating system or software inside, the herd surged and melted down the tangled mess of wires that made up the Russian economy.

In post-communist Poland, the economy sagged and then surged as reforms kicked in, because investors found there was a level playing field there, where the most productive companies won. "In Russia you didn't I'll do well by doing better, or by operating in accordance with best practices," said Bill Lewis, who headed a McKinsey consulting firm's study of the Russian economy. "You did well by seeking favors, tax preferences and subsidies."

What happened in Southeast Asia was another form of premature globalization. Thailand, Malaysia, South Korea and Indonesia are different from Russia. They had rudimentary free-market hardware all along.

And they even had early versions of the operating system-from DOScapital 3.0 to 4.0. These early versions of DOScapital-when combined with lots of savings, lots of government-backed credit, lots of natural resources and lots of people ready to labor very hard-worked well to get them from $500 per capita income to $5,000. Because, as we all know, when you first get a computer, any operating system will do, and it

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will always make you more productive than you were with a typewriter. But these early versions of DOScapital were relatively slow and rife with crony capitalism. In Indonesia, for instance, the management of state-owned banks was dominated by the Finance Ministry.

"When politicians, members of the President's family or Finance Ministry officials came calling, bankers felt compelled to extend loans even for projects they figured would be unprofitable, and when repayment of the loans became doubtful, they concealed the problems," wrote Shiraishi Takashi, a Kyoto University expert on Southeast Asian finance. "Private sector banks were also accumulating bad debts. Their function was to serve the business groups that had set them up, and when a member of the group ran into trouble, they would lend it additional funds brought in from foreign sources at high interest rates."

As the Electronic Herd shifted into high gear in the 1990s, and increased in power from a 286 chip to a Pentium II, it offered these Southeast Asian countries more and more money. Local banks, most of which were barely regulated, started excessively buying dollars, converting them into local currencies at a fixed rate, not hedging them in any way, and then lending that money out to their cronies for an increasing number of nonproductive investments-from one too many golf courses to the world's tallest office towers to egomaniacal expansions of South Korean conglomerates. The Southeast Asian nations needed to update their old DOScapital 3.0 to 4.0 and move closer to DOScapital 6.0. They needed more liberalized operating systems that would reduce the role of governments, let markets more freely allocate resources to their most productive uses, encourage more internal competition and weed out losers through effective bankruptcy laws. And they needed more sophisticated software that would improve the quality of governance, regulate a faster, more open economy, discipline company managers, open them up for shareholder scrutiny and be strong enough and flexible enough to handle any sudden large-scale withdrawal of foreign investment from the herd. Just throwing lots of capital and labor at an industry wasn't enough anymore to produce sustained, high growth.

Unfortunately, the Southeast Asians just stuck with DOScapital 3.0. Big mistake. DOScapital 3.0 was fine for getting from $500 to $5,000 per capita income, when the herd was moving at the speed of a 286 chip. But when they wanted to move from $5,000 per capita income to

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$15,000, and the herd moved from a 286 chip to a Pentium II, and they were still running DOScapital 3.0, their hardware naturally froze up. Have you ever seen what happens when you use an old, slow version of the DOS operating system and Windows software in a new Pentium II computer? What happens is that you get messages on your screen, such as "You Have Performed an Illegal Function," "Out of Memory" and "Cannot Save Item." This, in short, is what happened to the Southeast Asians in 1997-,98, only the messages that came up on their screens read: "You Have Performed a Series of Irrational Investments. Cannot Save Items. Delete Memory of All Inefficient Industries. Contact Service Provider and Download New Software and Operating System." And this is what they have been trying to do ever since.

What you found in all these Southeast Asian countries was that they replicated the outward configurations of the Western financial systems, but in many cases it was replication by rote. There was something missing inside-a key element of the DOS operating system. It was a basic feel and understanding how real free markets, and a free-market-based society, work-that they are not run by the arbitrary judgments of individuals, but by the anonymous working out of every value judgement in the marketeplace. The huge Korean conglomerates, the so-called Chaebols, would never have been able to build up the huge debt-to-equity ratios they did without the intervention of government officials arbitrarily directing capital their way. All this borrowing enabled them to grow at astronomical rates for a time, but in the end, it caught up with them.

Former Korean Prime Minister Lee Hong Koo told me that it took his government several years to understand this: "I was Prime Minister in 1995 when Korea was admitted to the OECD and reached $10,000 a year per capita income," he said. "We thought we had really finally arrived. We thought that because we had graduated from high school with honors, we were going to be great college students. But the qualities needed at one stage were very different at the next. We didn't realize that our big state bureaucracy, which we were so proud of, was more a stumbling block than a positive force. We lived by the formula that manufacturing plus exports equals economic growth and success. We learned that was wrong from the crisis [of the late 1990s], but the tuition is too high. We learned that the communist loss was a loss against capitalism and if capitalism won that meant that capital was in control. There was this rapid

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globalization of capital in the 1990s, but we had not prepared our institutions to deal with the global capital markets. We didn't have the mechanisms to deal with them. We were defenseless. We treated our banks as if they were a national service organization, as if they were an extension of government. We thought you, should not make money from money. We thought you should make money from making things. So the job of banks was to promote growth. So they were part of the government bureaucracy. We didn't understand that banks and capital flows were the heart of the new economy and either you reform them or else."

As Harvard University economist Dani Rodrik has demonstrated through his own research, it "is not whether you globalize that matters, it is how you globalize." Countries that have built up sophisticated, honest and credible financial and legal infrastructures-and this takes time-are much better positioned to fend off speculative attacks on their currencies, are much better able to withstand sudden outflows of capital by the herd, and are much faster at taking steps to minimize their impact. Yes, there are some exceptions. Even a country with a sound operating system and software can run into trouble-witness Sweden in 1992 or America and its savings and loan debacle. But Sweden and the United States also bounced back quickly because of the underlying quality of their operating systems and software. As Alan Greenspan has noted in speeches, those countries with advanced financial operating systems and software "generally have been able to discourage speculative attacks against a well-entrenched currency, because their financial systems are robust and are able to withstand large and rapid capital outflows [and to mobilize] the often vigorous policy responses required to stem such attacks."

For all these reasons there is now a growing awareness among leaders of developing countries that what they need in order to succeed in the globalization system is not just an emerging market but what former U.S. ambassador to Hungary Donald Blinken called "an emerging society." It does not pay to privatize your economy in a societal and governance vacuum. "Putting the market before the society," said Blinken, "is an invitation to trouble and disappointment." Therefore, it is critically important that both investors and politicians begin to broaden their definition of what constitutes a healthy emerging market, by looking at what constitutes a healthy emerging society. In retrospect, the biggest mistake the world made with Russia, when it succeeded

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the Soviet Union, was casting Russia's transition into the global system as primarily a "financial problem," and leaving it for the IMF to sort out-as if the only problem was freeing up prices the right way and trusting the free market to take care of everything.

World Bank president James Wolfensohn has proposed that we revise our methodology for measuring countries from the current checklist, which is almost entirely confined to financial statistics-GDP, GNP, per capita income-to "a new form of accounting" that would measure a country's health as an emerging society and not just as an emerging market. Countries must be graded on the quality of their governing software, judicial system, procedures for settling disputes, social safety net, rule of law and economic operating systems.

These so-called "second-generation" reforms needed to produce an emerging society take a lot more patience and hard work. "In the old days," a World Bank official once said to me, "you came into a developing country and you went to the governor of the Central Bank and you had one simple piece of advice: 'stop printing so much money.' Then you went over to the Minister of Finance and said, 'stop running such a big budget deficit so your Central Bank can stop printing so much money.' In other words, all you had to do was talk to two people and give two simple messages. But now we know that a lot more is required." And in order to get these second-generation software reforms in place, which really transform a country from an emerging market to an emerging society, you need to involve many, many more actors and it requires a much, much wider political consensus.

It has been said of America that it is a system designed by geniuses so that it could be run by idiots. What developing countries need most from America today is not aid. Rather, it is an understanding of what is the real source of American prosperity: the combination of the right operating system-free markets-with the right software, political institutions and political consensus that can protect property and innovation, maintain a level playing field, ensure that the most productive players usually win, and provide some minimum safety nets to catch the losers.

While all sorts of would-be Western geo-architects are talking about designing a new global central bank and new global governing institutions to control the Electronic Herd, leaders of many developing countries are coming to realize that none of that will protect them unless they

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have better local government. The bank laws and the legislatures that pass them, the executives and regulators who enforce them, and the courts that adjudicate them are all local institutions, and the focus must be on improving those bodies-not waiting for some celestial solution of global government. While many Western thinkers don't get this, the countries that have actually gone through economic crises in the 1990s get it very well.

"There are some voices, some very loud voices, saying that perhaps integration has gone too far and too quickly-especially in financial markets," Mexico's President Ernesto Zedillo told me in the winter of 1997. "Well, I happen to believe just the opposite. Globalization poses challenges, but it offers tremendous opportunities. The fact that finance capital can move instantaneously indeed poses a risk, but jumping from that to say that we need to control movements of capital is totally wrong." Yes, he added, we need a strong IMF to help in emergencies and to alert us to distortions in countries or individual banks. But at the end of the day, said President Zedillo, "all of these [global] financial flows end up in a local financial system, or as resources to be lent by local banks." So what matters, he added, is whether you have the local financial and political institutions to properly regulate the whole process.

In the Cold War countries did not care very much what sort of operating system or software their neighbors had, since they were not highly integrated. But today, in the globalization era, the ability of the herd to transmit instability from bad countries to good countries has vastly increased. The domino theory today belongs to the world of finance, not politics.

That's why one has to be a bit worried about the quick "recovery" the Asian economies made from the crisis of 1997-98. It wasn't because they had actually put in place all the reforms they needed to upgrade from DOScapital 1.0 to 6.0. In many cases it was because their currencies had become very cheap and they were the beneficiaries of strong U.S. demand for imports, particularly of electronics and computer parts made in Southeast Asia.

The Wall Street Journal (Oct. 28, 1999) profiled Indonesia's Rini Soewandi, who was appointed head of the Indonesia automaker Astra

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International after the company was nearly wiped out by Asia's late 1990s economic downturn. She really expressed the growing awareness among Asian entreprenuers of the changes that they need to put in place to thrive, but also how difficult they are to put in place.

"I follow the American way of doing business, but in my soul I'm a Javanese," said the forty-one-year-old Ms. Soewandi. The article then went on to say the following: "Ms. Soewandi is making a tough leap, attempting to transform the business soul of Astra, one of Southeast Asia's oldest and largest companies, from a clubby conglomerate to one of the region's first American-style public corporations. . . . The remaking of Astra signals the start of a new struggle for Southeast Asia as it looks beyond the crisis. With the worst behind them, many companies are waking up to the longer-term problem of surviving in a newly opened market. Most have avoided the issue, hoping that recovery will restore their fortunes. But Astra is meeting its troubles head-on and effecting a cultural makeover-moving from profligacy to transparency, from ego-driven conglomerate to market-driven niche player. 'It's a race against time,' Ms. Soewandi says. 'We're [trying] to do two huge things at once-survive the crisis and invent an entirely new business model that will carry us into the future. It's very difficult for a company to do one, let alone both.' "

While the rest of the world clearly has a stake in how these Asian trading partners manage their internal economic affairs, the ability of the U.S. government, or any others, to actually help them build the necessary software is very limited. They have to come to the task on their own. The U.S. Secretary of State likes to shuttle in an airplane, but to build soft-ware you have to shuttle in a taxicab-from the local Ministry of Justice to the stock market to the Ministry of Trade to the corporate headquarters. This is the stuff of micropolitics and microdiplomacy, which is totally foreign to most of today's diplomats.

So how to get at it? It would be nice if every society were able to get all its software and operating systems in place before it ever plugs into the Electronic Herd. But that is not realistic. The process is going to be much more chaotic-two steps forward, one step back. We now know it will be a process of countries, such as Russia or Brazil or Thailand, plugging in a little, getting burned by the herd and the herd getting burned by them, both of them learning certain lessons, implementing reforms,

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bouncing back a little, getting slapped down again, and then beginning the whole process anew, hopefully each time in a wiser manner. This is going to be a long-drawn-out learning process--one that could take a generation in a country such as Russia-that will dominate domestic politics and international relations in the era of globalization.

In this dialectical process, the Supermarkets and the Electronic Herd could end up playing a more important role than the American super-power in driving political reform. It would be great if every democracy movement could be spurred by a hero like Andrei Sakharov. It would be wonderful if every country could be nudged toward the rule of law by reading James Madison. But in the era we are heading into, the main engine of change could well be Merrill Lynch.

Article Citation:

Friedman, Thomas. 2000. The Lexus and The Olive Tree: Understanding Globalization. New York: Anchor Books.