CAMBRIDGE – The crisis in the eurozone is the result of France’s persistent pursuit of the “European project,” the goal of political unification that began after World War II when two leading French politicians, Jean Monnet and Robert Schuman, proposed the creation of a United States of Europe.

Monnet and Schuman argued that a political union similar to America’s would prevent the types of conflict that had caused three major European wars – an appealing idea, but one that overlooked America’s horrific Civil War. A European political union could also make Europe a power comparable to the United States, and thereby give France, with its sophisticated foreign service, an important role in European and world affairs.

The Monnet-Schuman dream led to the 1956 Treaty of Rome, which established a small free-trade area that was later expanded to form the European Economic Community. Establishing the EEC had favorable economic effects, but, like the North American Free Trade Area, it did not reduce national identification or create a sense of political unity.

That was the purpose of the 1992 Maastricht Treaty, which established the European Union. The influential report “One market, one money,” issued in 1990 under the leadership of the former French Finance Minister Jacques Delors, called for the creation of a single currency, relying on the specious argument that the single market could not function well otherwise. More realistically, advocates of a single currency reasoned that it would cause people to identify as Europeans, and that the shift to a single European Central Bank would herald a shift of power away from national governments.

Germany resisted the euro, arguing that full political union should come first. Since there was no chance that the other countries would accept political union, Germany’s position seemed like a technical maneuver to prevent the establishment of the single currency. Germany was reluctant to give up the Deutsche Mark, a symbol of its economic power and commitment to price stability. Germany eventually agreed to the creation of the euro only when French President François Mitterrand made it a condition of France’s support for German reunification.

Moreover, under pressure from France, the Maastricht Treaty’s requirement that countries could introduce the euro only if their national debt was less than 60% of GDP was relaxed in order to admit countries that were seen to be “evolving” toward that goal. That modification allowed Greece, Spain, and Italy to be admitted.

The pro-euro politicians ignored economists’ warnings that imposing a single currency on a dozen heterogeneous countries was bound to create serious economic problems. They regarded the economic risks as unimportant relative to their agenda of political unification.

But the creation of the euro caused a sharp fall in interest rates in the peripheral countries, leading to debt-financed housing bubbles and encouraging their governments to borrow to finance increased government spending. Amazingly, global financial markets ignored the credit risks of this sovereign debt, requiring only very small differences between interest rates on German bonds and those of Greece and other peripheral countries.

That ended in 2010, after Greece admitted that it had lied about its budget deficits and debt. Financial markets responded by demanding much higher rates on the bonds of countries with high government debt ratios and banking systems weakened by excessive mortgage debt.

Three small countries (Greece, Ireland, and Portugal) have been forced to accept help from the International Monetary Fund, and to enact painful contractionary fiscal cuts. The conditions in Greece are now hopeless, and are likely to lead to further defaults and a withdrawal from the eurozone. Spain, too, is in serious trouble, owing to the budget deficits of its traditionally independent regional governments, the weakness of its banks, and its need to roll over large sovereign-debt balances each year.

It is already clear that the EU’s recently agreed “fiscal compact” will not constrain budget deficits or reduce national debts. Spain was the first to insist that it could not meet the conditions to which it had just agreed, and other countries will soon follow. French President François Hollande has proposed balancing deficit limits with growth initiatives, just as France had earlier forced the EU’s Stability Pact to become the Stability and Growth Pact. The fiscal compact is an empty gesture that may be the last attempt to pretend that EU members are moving toward political unification.

The European project has clearly failed to achieve what French political leaders have wanted from the beginning. Instead of the amity and sense of purpose of which Monnet and Schuman dreamed, there is conflict and disarray. Europe’s international role is shrinking, with the old G-5 having evolved into the G-20. And, with German Chancellor Angela Merkel setting conditions for the eurozone, France’s ambition to dominate European policy has been thwarted.

Even if most eurozone countries retain the single currency, it will be because abandoning the euro would be financially painful. Now that its weaknesses are clear, the euro will remain a source of trouble rather than a path to political power.

CAIRO – Everything about Egypt’s revolution has been unexpected, and the first-round results in the country’s first-ever competitive presidential election are no different. The rise of former President Hosni Mubarak’s last prime minister, General Ahmad Shafiq, who will enter the presidential runoff alongside the Muslim Brothers (MB) candidate Mohamed Morsi, has raised eyebrows across the political spectrum. So did the meteoric rise of the Nasserist candidate Hamdin Sabbahi to third place, and the fourth-place finish of Abdel Moneim Aboul Fotouh, who was backed by liberals and hardline Salafi Islamists alike.

Egypt’s voters overwhelmingly chose the revolution over the old regime, and shattered the myth that the push for change is an urban, middle-class, Cairo-based phenomenon: the eight revolutionary candidates received more than 16.4 million votes. But their failure to unite on a single platform directly benefited Shafiq, who unexpectedly won 5.9 million votes (assuming no election-rigging).

Shafiq’s success shocked many revolutionaries. “He is a murderer. His place is in jail, not on top of Egypt after the revolution,” said one activist. Indeed, Shafiq has been linked to multiple cases of corruption and repression, including the “battle of the camels” on February 2, 2011, when Mubarak’s henchmen attacked Tahrir Square, killing and wounding protesters.

The rise of Shafiq is explainable in some areas, but raised eyebrows in others. In Upper Egypt, “more than 60% of Copts voted for him,” a source close to the Coptic Orthodox Church said, and in Coptic-majority areas, the pro-Shafiq vote exceeded 95%, because he was widely perceived as a bulwark against Islamism.

Moreover, many state employees (around 5.1 million of them eligible to vote) and their families supported Shafiq, owing either to direct instructions from their bosses, or to the perceived threat of creeping MB influence on government bureaucracies. And Shafiq received financing and support from Mubarak’s National Democratic Party (NDP), as well as from business and security interests that benefited from the status quo.

But this was not enough to explain Morsi’s defeat in the MB’s traditional strongholds. In Sharqiya, a bastion of hardcore MB support with 3.5 million voters, Shafiq defeated Morsi by more than 90,000 votes. In Gharbiya governorate, another MB stronghold, he beat Morsi by more than 200,000 votes.

I compared the results with the MB’s performance in the parliamentary elections earlier this year, and found that the Brothers lost between 25% and 48% of their support in the Nile Delta (depending on the area), where 40% of Egyptians live. Assuming no foul play, Shafiq received around two million votes from four Delta governorates: Sharqiya, Gharbiya, Munufiya, and Daqahliyya.

Egypt’s Islamists – the strongest political force on the ground, and the most repressed under Mubarak – have serious stakes in this election. But, rather than uniting to improve their chances, their popular support was split among three candidates, two of whom – Morsi and Aboul Fotouh – placed among the four front-runners.

Salafi support for Aboul Fotouh, a moderate former MB leader, proved to be a double-edged sword, because it repelled many liberals and socialists who would have voted for him otherwise. Most revolutionaries who did not want an Islamist-dominated Egypt were alienated as well. Their votes went to Hamadi Sabbahi, from the left-leaning Nasserist camp, who surprised observers by winning 5.4 million votes.

If anything, the first-round results revealed the power of the non-Islamist revolutionary bloc, as well as Egyptians’ willingness to punish Islamists for their weak job performance in the parliament. Indeed, six out of ten Egyptians voted for Islamists in the parliamentary elections. That dropped to four in ten in the presidential election.

Morsi, who finished first, with six million votes, had the MB’s disciplined, dedicated, and experienced machine fully behind him. That meant a sophisticated election campaign that penetrated deeply into Egyptian society, urban and rural, and in which women played a key role. “This is where they beat the Salafis. Their women are experienced, outgoing, gutsy, and trained to be convincing and charismatic,” a Salafi activist who supported Aboul Fotouh told me. “Salafi women are shy, introverts. They can’t compete for votes with the MB ladies.”

The MB must now try to persuade the 10.7 million voters who supported Aboul Fotoh and Sabbahi to back Morsi in the runoff against Shafiq. The MB probably needs to reserve the vice presidency for a non-Islamist like Sabbahi. Likewise, Aboul Fotoh, or perhaps the Nobel laureate Mohamed ElBaradei, will need to be appointed as Prime Minister. Moreover, the MB will most likely have to offer some concessions to guarantee balanced representation of Islamists and non-Islamists in the assembly that the parliament is to choose to draft a new constitution.

Whoever wins Egypt’s presidency will face severe obstacles in challenging the status quo, owing to the dominance of the Supreme Council of the Armed Forces (SCAF). The president’s mandate was outlined by a constitutional declaration in March 2011, but the SCAF has said that a more detailed one would be forthcoming after the election. That could mean weakening the president’s powers and reserving some domains for the army – at least until a new constitution is adopted.

What remains certain is that no democratic transition can be complete without elected representatives exercising meaningful control over the security services and the armed forces. That will be the Egyptian revolution’s ultimate test, and the most critical challenge for any president who does not embody a return to the past.

DUBLIN – “The construction of Europe is an art,” former French President Jacques Chirac once said. “It is the art of the possible.” If so, then Europe’s deconstruction – or, worse, its collapse – would be a shockingly fearful and painful business.

That was the situation faced by European leaders last autumn. The euro was in serious trouble, buffeted by rumors of imminent banking collapses. Bond yields in southern Europe were rising, and a pervasive sense of apprehension and fear cloaked governments in European capitals. But political leadership was sorely lacking.

Finally, in December, decisive action was taken. There would be a “fiscal treaty,” which would reinforce the Stability and Growth Pact and, importantly, entail automatic sanctions to ensure that eurozone members stick to those rules. At the same time, the European Central Bank unleashed its €1 trillion ($1.3 trillion) long-term refinancing operation, which pulled the European banking system back from the brink.

These two measures were both timely and vital, creating a much-needed period of calm. In March, having agreed on the fiscal treaty, the European Council turned its attention to reviving economic growth, which will be the key to long-term fiscal sustainability.

In Ireland, our attorney-general advised on the need to hold a referendum on the fiscal treaty, and we are now in the midst of the campaign. The government parties, Fine Gael and Labour, as well as the largest opposition party, Fianna Fáil, are campaigning tirelessly for a yes vote.

The reasons we are backing the fiscal treaty are simple. The treaty would promote stability in the Irish economy and contribute to stabilizing the euro, our currency. It would increase confidence in Ireland and allow us to increase the existing flow of inward foreign direct investment. Ratification would also give us guaranteed access to funding from the European Stability Mechanism (ESM), should we ever need it.

The ESM is Ireland’s insurance policy as we work our way out of the bailout program with the “troika” (the European Commission, the ECB, and the International Monetary Fund) and return to the markets. Most importantly, the fiscal treaty promises to ensure responsible budgeting throughout the eurozone. For us, that means that the economic mismanagement that caused the Irish economy’s collapse would never recur. It would also mean stable European economies to which we can export.

For Ireland to continue on the path of economic recovery, it needs to be seen as part of the solution, not part of the problem. We are making progress, and we need to continue doing so. Ireland’s government has exceeded its targets under the troika program, and the economy returned to growth last year.

International investors are increasingly looking at Ireland as a smart place to do business. They recognize the dynamic, transparent, and competitive fundamentals of the Irish economy. We are highly regarded around the world as an excellent export base. Global companies recognize that, as the only English-speaking member of the eurozone, Ireland is ideally placed as a gateway to Europe.

Indeed, Ireland is ranked as the best place in Europe to do business, the easiest in Europe for paying taxes, and number one in Europe for completion of tertiary education. We are an open, transparent economy with a highly skilled workforce and a market of 500 million people on our doorstep. Crucially, we are also a member of the second-largest currency area in the world.

Foreign direct investment accounts by more than 1,000 overseas companies translates into 145,000 jobs in Ireland, 70% of total exports, and €2.8 billion in corporate-tax receipts. These companies spend €16 billion per year on goods, services, and wages in Ireland.

The latest figures show that 2011 was a very strong year for attracting investment into the Irish economy, with a record 148 new projects – a 30% increase in companies investing in Ireland for the first time – implying an additional 13,000 jobs.

Investors come here because they link Ireland’s eurozone membership to our long-term economic stability and access to outside support if necessary. By voting for the fiscal treaty, we can guarantee that stability and support – and thus guarantee continued confidence and investment in the Irish economy.

The new treaty reflects clear recognition that the euro’s initial design was flawed. We spoke about European Monetary Union, but we didn’t have it. The Stability and Growth Pact, contained in the Maastricht Treaty, laid down strict rules of budgetary discipline, which were immediately violated – and not by small countries, but by both France and Germany.

Irish recovery cannot occur without European recovery. We must stand together or fall together, because our economies are so interconnected. This involves putting our public finances in order, which the fiscal treaty allows. We have begun that process; the next stage will be an unwavering focus on growth and economic renewal throughout the European Union.

WASHINGTON, DC – In an era in which conventional models of finance, corporate governance, and corporate responsibility are increasingly debated, if not called into question, it may be time to revisit the alternative approach taken by economic cooperatives. The foundational values of cooperatives embody not only a humane vision, but also a pragmatic approach to production that has enabled the successful ones to thrive – and to spur economic growth in countries that desperately need it.

Cooperative movements took shape in the Americas, Europe, Australia, and Japan in the 1800’s. Many grew from the simple proposition that ordinary people could overcome adversity in the marketplace by banding together to buy and sell goods at reasonable prices, and quickly realized the added benefits of sharing knowledge among members, promoting inclusion, and building social capital.

Today, cooperatives cover a range of activities and come in a variety of shapes and sizes, from small-scale agricultural and consumer organizations in Africa to some of the leading agricultural brands and largest financial-service providers in North America and Europe.   

According to the International Cooperative Alliance, a cooperative is a “jointly owned and democratically controlled enterprise.” But, beneath this definition lie rich notions of voluntary association, accountability for strategic decisions, and concern for the communities that cooperatives serve.

Cooperatives have helped to bring information and services to far flung rural communities, empower workers, and expand financial services, healthcare, education, and housing. In doing so, they have transformed the economic and social landscape in countless communities. The International Cooperative Alliance reports that more than 800 million people are members of cooperatives worldwide.

Moreover, cooperatives account for a significant share of GDP in many countries, and an especially high share of the agricultural and consumer sectors. Cooperatives are also one of the largest providers of financial intermediation to the poor, serving an estimated 78 million people globally who live on less than $2 per day.

Of course, cooperatives have sometimes struggled to live up to the ideal. In the most egregious cases, some have fallen victim to bad politics, weak governance, or mismanagement. Others are exposed to risks stemming from concentration in a single business sector, commodity, and/or geographic area.

Cooperatives have also wrestled with questions of members’ entry and exit, financial disclosure, and relationships with the non-cooperative sector. And governments have often faced vexing questions with regard to financial regulation and taxation of cooperatives, including treatment of profits and consideration of exemptions.

And now, in a more mobile and urban world, one might ask: can cooperatives maintain their essential character, based on inclusion and knowledge sharing within a community? In a world in which geography is a diminishing barrier to business, can cooperatives sufficiently distinguish themselves as a viable alternative model? Or will they evolve to serve virtual communities, organized around new sets of challenges and opportunities?

The United Nations has declared 2012 the “Year of Cooperatives.” This provides a good opportunity to examine the extraordinary history of cooperatives, assess their strengths and weaknesses, and rekindle a discussion about a development model that promises higher levels of inclusion, ownership, self-determination, and concern for community.

The World Bank is active in the development of producer and credit cooperatives around the world. Some of the most notable programs include the Indian Dairy Cooperative, which has created an estimated 250,000 jobs, mostly in rural areas. Similarly, Mexico’s National Savings and Financial Services Bank has helped to strengthen savings and credit institutions that serve millions of rural residents who would otherwise have been relegated to the margins of the formal financial sector.

The Bank’s policy work has re-affirmed the notion that rural producer organizations are fundamental building blocks of agricultural development. And it has helped governments to supervise and regulate cooperative financial institutions.

As we search for innovative solutions to today’s development challenges, we should consider what the cooperative movement can offer. That means not only greater economic inclusion, higher agricultural productivity, strengthened food security, and financial stability, but also lessons concerning responsible and sustainable business practices, corporate governance, and community relations. And we should consider how to facilitate the spread of cooperatives’ best practices while avoiding common pitfalls.

The cooperative movement can prompt us to think in new, inspired ways. Capitalizing on cooperatives’ successes and learning from their mistakes can help us to expand the menu of options as we search for more inclusive and sustainable models of development, and new ways of building and sharing knowledge.

BERLIN – Europe’s situation is serious – very serious. Who would have thought that British Prime Minister David Cameron would call on eurozone governments to muster the courage to create a fiscal union (with a common budget and tax policy and jointly guaranteed public debt)? And Cameron also argues that deeper political integration is the only way to stop the breakup of the euro.

A conservative British prime minister! The European house is ablaze, and Downing Street is calling for a rational and resolute response by the fire brigade.

Unfortunately, the fire brigade is being led by Germany, and its chief is Chancellor Angela Merkel. As a result, Europe continues to try to quench the fire with gasoline – German-enforced austerity – with the consequence that, in a mere three years, the eurozone’s financial crisis has become a European existential crisis.

Let’s not delude ourselves: if the euro falls apart, so will the European Union (the world’s largest economy), triggering a global economic crisis on a scale that most people alive today have never experienced. Europe is on the edge of an abyss, and will surely tumble into it unless Germany – and France – alters course.

The recent elections in France and Greece, together with local elections in Italy and continuing unrest in Spain and Ireland, have shown that the public has lost faith in the strict austerity forced upon them by Germany. Merkel’s kill-to-cure remedy has run up against reality – and democracy.

We are once again learning the hard way that this kind of austerity, when applied in the teeth of a major financial crisis, leads only to depression. This insight should have been common knowledge; it was, after all, a major lesson of the austerity policies of President Herbert Hoover in the United States and Chancellor Heinrich Brüning in Weimar Germany in the early 1930’s. Unfortunately, Germany, of all countries, seems to have forgotten it.

As a consequence, chaos looms in Greece, as does the prospect of subsequent bank runs in Spain, Italy, and France – and thus a financial avalanche that would bury Europe. And then? Should we write off what more than two generations of Europeans have created – a massive investment in institution-building that has led to the longest period of peace and prosperity in the history of the continent?

One thing is certain: a breakup of the euro and the EU would entail Europe’s exit from the world stage. Germany’s current policy is all the more absurd in view of the bitter political and economic consequences that it would face.

It is up to Germany and France, Merkel and President François Hollande, to decide the future of our continent. Europe’s salvation now depends on a fundamental change in Germany’s economic-policy stance, and in France’s position on political integration and structural reforms.

France will have to say yes to a political union: a common government with common parliamentary control for the eurozone. The eurozone’s national governments already are acting in unison as a de facto government to address the crisis. What is becoming increasingly true in practice should be carried forward and formalized.

Germany, for its part, will have to opt for a fiscal union. Ultimately, that means guaranteeing the eurozone’s survival with Germany’s economic might and assets: unlimited acquisition of the crisis countries’ government bonds by the European Central Bank, Europeanization of national debts via Eurobonds, and growth programs to avoid a eurozone depression and boost recovery.

One can easily imagine the ranting in Germany about this kind of program: still more debt! Loss of control over our assets! Inflation! It just doesn’t work!

But it does work: Germany’s export-led growth is based on just such programs in the emerging countries and the US. If China and America had not pumped partly debt-financed money into their economies beginning in 2009, the German economy would have taken a serious hit. Germans must now ask themselves whether they, who have profited the most from European integration, are willing to pay the price for it or would prefer to let it fail.

Beyond political and fiscal unification and short-term growth policies, Europeans urgently need structural reforms aimed at restoring Europe’s competitiveness. Each of these pillars is needed if Europe is to overcome its existential crisis.

Do we Germans understand our pan-European responsibility? It certainly does not look that way. Indeed, rarely has Germany been as isolated as it is now. Hardly anyone understands our dogmatic austerity policy, which goes against all experience, and we are considered largely off-course, if not heading into oncoming traffic. It is still not too late to change direction, but now we have only days and weeks, perhaps months, rather than years.

Germany destroyed itself – and the European order – twice in the twentieth century, and then convinced the West that it had drawn the right conclusions. Only in this manner – reflected most vividly in its embrace of the European project – did Germany win consent for its reunification. It would be both tragic and ironic if a restored Germany, by peaceful means and with the best of intentions, brought about the ruin of the European order a third time.

PALO ALTO – Elections often turn on the state of the economy, especially in hard times. When growth and jobs are down, voters throw out incumbents – whether Spanish leftists, French rightists, or Dutch centrists. The United States is no exception. Three years into the Great Depression, Herbert Hoover was trounced by Franklin Delano Roosevelt. In 1980, following a severe bout of stagflation, Ronald Reagan routed Jimmy Carter.

At the same time, economic performance depends to a considerable extent on economic policy. The Great Depression was intensified by poor monetary policy, tax hikes, and protectionist trade policies. Likewise, loose US monetary policy in the middle of the last decade helped to set the stage for the Great Recession by contributing significantly to an explosion of leverage and fueling the housing bubble that burst in 2007-2008.

The outcome of two related policy battles will be key to the economic and political outlook in both the US and Europe. The first is between “austerity” and “growth” – that is, short-term deficit reduction and additional fiscal stimulus. Many on the left, on both sides of the Atlantic, argue that more, not less, government spending is required to lift their economies out of recession. Those on the right believe that governments’ top priority should be fiscal consolidation.

In Europe, large deficits and exploding debt-to-GDP ratios have alarmed creditors and provoked political tension. In particular, Germany demands more fiscal belt-tightening from heavily indebted Southern European countries, whose unions (and voters) are rejecting further austerity. While the US has thus far avoided the bond market’s wrath, American political leaders confront the same problem of debt and fiscal sustainability.  

The second battle involves long-run structural issues: slowing the growth of government spending, reforming taxes, and increasing labor-market flexibility. In Europe, for example, raising the retirement age for public pensions and shrinking government employment would curtail welfare-state excesses.

In the US, Reagan’s victory in 1980 appeared to signal that America would stop well short of the European social-welfare model. But President Barack Obama and his congressional allies have rejected the consensus that government should be only a last resort for those in need, in favor of greater dependence, for both individuals and firms, on entitlement programs and other public spending, targeted tax breaks, regulations, and loans.

Separating the budget’s effects on the economy from those of the economy on the budget is tricky. There are several cases – Ireland and Denmark in the 1980’s, for example – in which fiscal consolidation helped to expand the economy in the short run, as lower interest and exchange rates boosted confidence enough to stimulate demand.

Of course, if many of the world’s economies attempt to consolidate simultaneously, with interest rates already low and some of the largest in a monetary union, such a favorable result is less likely. But the evidence on whether additional deficit-financed spending would quickly revive economic growth is mixed.

In a recent survey, “Fiscal Policy for Economic Growth,” I concluded that short-run multipliers – the total change in economic activity resulting from higher government spending – could theoretically be as large as two when the central bank has reduced its target interest rate to zero. In other words, one dollar spent by the government could boost GDP by two dollars in the very short run.

The catch is that the multiplier turns negative by year two: extra government spending contracts, rather than expands, medium-term and long-term economic growth. Moreover, the short-run effect is lower in highly indebted countries, and can even be negative during economic expansions if households and firms, expecting higher taxes to pay for future spending, save, rather than spend, the cash.

Postponing fiscal consolidation risks aborting it, but consolidating too aggressively risks temporarily hindering growth. But those now demanding further deficit-financed stimulus must confront considerable evidence that an overhang of public debt impedes growth for a long time. In a recent paper following up on their book This Time is Different, the economists Carmen Reinhart and Kenneth Rogoff concluded that debt/GDP ratios above 90% tend to be associated with an annual growth slowdown of a full percentage point for 23 years. Thus, a debt overhang cumulatively costs more in lost income than a deep recession does.

Wise policy simultaneously considers short-, medium-, and long-term effects. Both Europe and the US badly need long-run reforms, for example, of public pensions and health care. Europe requires structural labor-market reform and must resolve its sovereign-debt overhang, banking crises, and the euro’s future. America must reform its tax code to raise revenue across a wider array of people and economic activity (half the US population pays no federal income tax, and the tax code either excludes or favorably treats many income sources).

Over the next several years – the medium term – all countries should implement difficult-to-reverse fiscal consolidation, which would persuade the private sector that a gradual or delayed adjustment, primarily on the spending side of the budget, will occur. Successful consolidation generally relies on spending cuts rather than tax increases – indeed, at a ratio of five or six to one. The US in the 1980’s and 1990’s reduced spending by 5% of GDP and balanced its budget while growing strongly. Canada, in the past two decades, has decreased spending by 8% of GDP and similarly prospered.

In the short run, spending flexibility is appropriate only if medium- and long-term measures are in place. That compromise – between Germany and Southern Europe, and between US Republicans and Democrats – should be economically and politically feasible.

With many citizens now struggling, political leaders face a daunting task: adopt credible medium- and long-term reforms without derailing the economy in the short term. They have little economic – and perhaps even less political – margin for error.

TOKYO – China is now engaged in bitter disputes with the Philippines over Scarborough Shoal and Japan over the Senkaku Islands, both located far beyond China’s 200-mile-wide territorial waters in the South China Sea. Indeed, so expansive are China’s claims nowadays that many Asians are wondering what will satisfy China’s desire to secure its “core interests.” Are there no limits, or does today’s China conceive of itself as a restored Middle Kingdom, to whom the entire world must kowtow?

So far, China has formally referred to Taiwan, Tibet, and Xinjiang province as “core interests,” a phrase that connotes an assertion of national sovereignty and territorial integrity that will brook no compromise. Now China is attempting to apply the same term to the Senkaku Islands in its dispute with Japan, and is perilously close to making the same claim for the entire South China Sea; indeed, some Chinese military officers already have.

The Senkaku Islands, located to the west of Okinawa in the East China Sea and currently uninhabited, were incorporated into Japan by the Meiji government in 1895. At one time, there were regular residents working at a bonito-drying facility. In 1969, the United Nations Economic Commission for Asia and the Far East (ECAFE) completed a seabed survey of the East China Sea, and reported the possible presence of vast underground mineral resources, including abundant oil and natural gas reserves near the Senkakus. Two years passed before Taiwan and China claimed sovereignty over the islands, in 1971, but the Japanese government’s stance has always been that Japan’s sovereignty is not in question.

In April, Tokyo Governor Shintaro Ishihara, a famous and articulate patriot, announced that the metropolitan government that he leads plans to acquire four of the Senkaku Islands, which are currently privately owned by Japanese citizens. Donations for the purchase from the people of Japan now exceed ¥700 million ($8.4 million).

China reacted to Ishihara’s proposal with its usual sensitivity: it refused to receive the scheduled visit of Ishihara’s son, who is Secretary-General of Japan’s Liberal Democratic Party, the country’s main opposition party.

Moreover, at a meeting in Beijing earlier this month between Japanese Prime Minister Yoshihiko Noda and Chinese Premier Wen Jiabao during a trilateral summit with South Korea, Wen mentioned the independence movement in the Xinjiang Uyghur Autonomous Region and the Senkaku Islands in the same breath. “It is important to respect China's core interests and issues of major concern,” he emphasized.

Until that moment, the Chinese government had never applied the term “core interest” to the Senkaku Islands. Following Wen’s statement, the trilateral summit deteriorated. While South Korean President Lee Myung-bak held bilateral talks with Chinese President Hu Jintao, talks between Noda and Hu, and a scheduled meeting between Keidanren Chairman Hiromasa Yonekura and Chinese Foreign Minister Yang Jiechi, were also canceled. The joint declaration issued at the summit was delayed a day, and omitted all references to North Korea – a prime concern of both Japan and South Korea.

China’s brusque treatment of Japan’s leaders probably was intended as a rebuke not only over the Senkaku Islands issue, but also for hosting the Fourth General Meeting of the World Uyghur Congress in Tokyo in May. Previously, such meetings had been held in Germany and the United States, and this one, which stressed the importance of protecting human rights and preserving the traditions, culture, and language of the Uyghur people, received no official sanction or endorsement from the Japanese government.

If gruff diplomacy was the only manifestation of China’s expansive territorial claims, Asian leaders could sleep more peacefully. But the fact is that China’s navy is becoming increasingly active in the South China Sea, at the Senkaku Islands and Scarborough Shoal in particular, but also around the Spratly Islands claimed by Vietnam. Given China’s mushrooming military budget and secretiveness, that assertiveness has set off alarm bells among the other countries bordering the South China Sea.

Moreover, China’s bullying of the Philippines included not only the dispatch of warships to Scarborough Shoals, but also the sudden imposition of import restrictions on Filipino produce. And China’s reactions toward Japan are far more paranoid since a non-LDP government took power.

The struggles for power within China’s ruling Communist Party over the purge of Bo Xilai, and the blind activist Chen Guangcheng’s escape from detention during economic talks with the US, have made Chinese leaders’ nationalist assertions even more strident than usual. No official wants to appear soft where China’s supposed “core interests” are concerned.

So far, China has not unleashed the sort of mass demonstrations against Japan and others that it has used in the past to convey its displeasure. But that probably reflects the jittery state of China’s leaders in the wake of the Bo purge: they cannot guarantee that an anti-Japan demonstration would not turn into an anti-government protest.

China’s real core interests are not in territorial expansion and hegemony over its neighbors, but in upholding the human rights and improving the welfare of its own citizens, which is the world’s core interest in China. But until China accepts that its territorial claims in the South China Sea must be discussed multilaterally, so that smaller countries like the Philippines and Vietnam do not feel threatened, China’s ever expanding “core interests” will be the root of instability in East Asia.

MILAN – Over the years, advanced and developing countries have experimented, sometimes deliberately and frequently inadvertently, with a variety of approaches to growth. Unfortunately, many of these strategies have turned out to have built-in limitations or decelerators – what one might call elements of unsustainability. And avoiding serious damage and difficult recoveries requires us to get a lot better at recognizing these self-limiting growth patterns early on.

Here are some of the items in a growing library of decelerating growth models.

In developing countries, import substitution as a way to jump-start economic diversification can work for a while; but, over time, as productivity growth lags and comparative advantage is over-ridden, growth grinds to a halt.

Small, open economies are naturally somewhat specialized, which leaves them vulnerable to shocks and volatility. But, in terms of growth and living standards, the cost of economic diversification, when implemented by protecting domestic industries from foreign competition, eventually outweighs the benefits. It is better to allow specialization, and build effective social safety nets and support systems to protect people and families during economic transitions. Such “structural flexibility” is better adapted to enabling the broad changes that rapidly evolving technological and global economic forces require.

Mismanagement of natural-resource wealth underpins an especially potent self-limiting pattern of growth and development. If invested in infrastructure, education, and external financial assets, natural-resource revenues can accelerate growth. But, too often, such revenues distort economic incentives, which come to favor rent-seeking and interfere with the diversification that is essential for growth.

More recently, many advanced countries have discovered a “new” set of growth models with built-in structural limitations: excessive private or public consumption, or both, usually accompanied and enabled by rising debt and inflated asset prices, and a corresponding decline in investment. This approach appears to work until domestic aggregate demand can no longer sustain growth and employment, at which point it ends in either gradual stagnation or a violent financial and economic crisis. (In fact, many developing countries have learned this the hard way, but the lessons seem not to have crossed over to advanced countries.)

But the opposite of the excessive-consumption model – excessive reliance on investment to generate aggregate demand – is also a self-limiting growth pattern. When the private and social returns of investment diminish too much, growth cannot be sustained indefinitely, even though rising investment rates can sustain aggregate demand for a while. Altering this growth pattern is a significant part of the challenge that China now faces.

Rising inequality in either opportunity or outcomes (and often both) also poses threats to the sustainability of growth patterns. While people in a wide range of countries accept some degree of market-determined income variation, based on differential talents and personal preferences, there are limits. When they are breached, the typical result is a sense of unfairness, followed by resistance and, ultimately, political choices that address the inequality, though sometimes in counter-productive, growth-impeding ways.

Perhaps the largest long-run sustainability issue concerns the adequacy of the global economy’s natural-resource base: output will more than triple over the coming two or three decades, as high-growth developing economies’ four billion people converge toward advanced-country income levels and consumption patterns. Existing economic-development strategies will require significant adaption to accommodate this kind of growth.

Some adaptation will occur naturally, as rising energy and other commodity prices generate incentives to economize or seek alternatives. But the un-priced environmental externalities – global warming and water depletion, for example – will require serious attention, not myopic, reactive mindsets and approaches. 

All of these self-limiting growth patterns tend to have three things in common. First, in one or several dimensions, some part of the economy’s base of tangible, intangible, and natural-resource assets is being run down. I would include social cohesion as part of the asset base: it is the one that is depreciated by excessive inequality.

Measurement issues play an important role here. It is easier to run down something that is partly invisible because it is not regularly or effectively measured. Expanded measurement of the dimensions of economic, social, and environmental performance is necessary to broaden awareness of sustainability issues.  

Second, unidentified self-limiting growth patterns produce very bad results. Expectations come to exceed reality, and resetting the system to a sustainable growth pattern is difficult. After all, past investment shortfalls have to be made up and future-oriented investments undertaken simultaneously – a double burden that must be borne by the current generation. An inability to resolve the distributional and fairness problem can produce gridlock, paralysis, and prolonged stagnation.

Finally, many of these flawed growth patterns involve fiscal distress. Contrary to the prevailing wisdom nowadays, some degree of Keynesian demand management in the transition to a more sustainable growth pattern is not in conflict with restoring fiscal balance over a sensible time period. On the contrary, applied both individually and together, fiscal stimulus and consolidation are necessary parts of the adjustment process.

But they are not sufficient. The crucial missing pieces are a shift in the structure of accessible aggregate demand and restoration of those parts of the economy’s asset base that have been run down, implying the need for structural change and investment.

CANBERRA – You wouldn’t expect much interest beyond the United States, or even beyond his own state, when an 80-year-old conservative legislator, who has already served six terms, loses his party’s endorsement to run yet again. But the crushing defeat of Senator Richard Lugar in the recent Indiana Republican primary, in a Tea Party-supported campaign of shocking mindlessness, has reverberated in capitals around the world, including my own.

On most issues, Lugar is and always has been a natural conservative. In recent times, he opposed all of President Barack Obama’s major domestic legislation, including the economic stimulus package, health-care reform, and financial-services regulation, and has consistently supported anti-abortion legislation. With his 36-year record in the US Senate, national stature, and essentially conservative constituency, he would certainly have won again in November. But none of this was persuasive enough for Indiana primary voters, who backed his rival, State Treasurer Richard Mourdock, by an astonishing 20-point margin.

The problem for Lugar was two-fold. First, he was of the old school that instinctively embraced compromise across party lines in the Senate on crucial issues, in order to avoid the kind of gridlock that is always potentially endemic in a presidential system (unlike a parliamentary one), where the elected executive has no guaranteed majority in the legislature. If party lines are strictly maintained, US presidents may be unable to pass any legislation at all, or to make any judicial or other senior appointments.

Lugar, for example, had voted to confirm Obama’s Supreme Court nominations. Mourdock’s position, by contrast, was that, “Bipartisanship ought to consist of Democrats coming to the Republican point of view.”

Second, and most alarmingly for those around the world who crave decent and intelligent international leadership from the US, Lugar was mocked by his opponents for his foreign-policy expertise and reputation as an outstanding statesman, who for decades had played an absolutely central role on arms control and disarmament issues. His signature achievement was joint authorship with then-Democratic Senator Sam Nunn of the 1992 Cooperative Threat Reduction program (universally known as “Nunn-Lugar”), which successfully secured and dismantled nuclear and other weapons of mass destruction in former Soviet states.

Beyond that, Lugar had fully supported Obama’s vision, like that of Ronald Reagan before him, of a world without nuclear weapons, and his endorsement of the New START treaty with Russia, reducing the number of deployed strategic weapons, was crucial in securing its narrow ratification by the Senate last year. But, for Mourdock and his supporters, “The time for being collegial is past – it’s time for confrontation.”

One television advertisement said it all about the low-rent cynicism of the Tea Party-driven campaign. It featured two clips of Obama saying, “I’ve worked with Republican Senator Dick Lugar to pass a law,” and, “What I did was reach out to Senator Dick Lugar.” The context was not explained, but what Obama said in full was this: “I’ve worked with Republican Senator Dick Lugar to pass a law that will secure and destroy some of the world’s deadliest, unguarded weapons,” and, “What I did was reach out to Senator Dick Lugar, a Republican, to help lock down loose nuclear weapons.”

With the defeat of Lugar, and the simultaneous exit of the last Republican moderates, like Senator Olympia Snowe of Maine, who were prepared to put national interests ahead of partisanship, the Senate is unlikely to produce the 60 votes needed to ratify further US-Russia arms-control treaties, should they be negotiated. Moreover, the Comprehensive Nuclear Test Ban Treaty, which would replace a fragile international moratorium, cannot come into force without US Senate ratification.

At a personal level, I am also afraid that Lugar’s defeat may be the end of an era of enormously attractive and distinctive civility in the way that America’s most senior legislators conducted themselves. As Australia’s foreign minister, and a global NGO head, I met Lugar many times, and, whether or not we agreed on issues, he was always a model of gentle courtesy.

I can’t help but compare that to the occasion, not so long ago, when I accompanied my then co-chair of the International Commission on Nuclear Non-Proliferation and Disarmament, former Japanese Foreign Minister Yoriko Kawaguchi, in a call on Jon Kyl, the most ideologically fierce Senate opponent of Obama-style arms control. On my arrival in his office, a senior Kyl staffer, after consulting the senator, said brusquely: “We only agreed to talk to the Japanese, not you. Would you please leave?”

There was nothing like a perfectly understandable, “Sorry, we misunderstood, and are only prepared now for a bilateral session. Can we see if we can possibly reschedule a joint meeting later?” I suppose that I should be grateful that he said “please.” But it’s the kind of experience that I had never had before in Washington, and I fear that it’s not unique.

In the past, anguish at home and abroad about the quality of US governance – its apparent arrogance, mindless parochialism, and incapacity to deliver coherent, credible, and decent policy outcomes – has for the most part proved short-lived. Maybe that will be the case again. But the passing from the national stage of Richard Lugar has properly rung new alarm bells not only among concerned Americans, but also among policymakers far removed from the US and its partisan battles.

NEW YORK – Recent political developments, including the defeat of incumbent governments in France and Greece, suggest that the public’s tolerance for economic policies that do not reduce unemployment has collapsed. Indeed, given the alarming economic and employment situation in many countries today, with no prospect of recovery on the horizon, further political turmoil is likely unless policymakers change course accordingly.

The economic crisis has wiped out more than 50 million jobs after years of weak, job-poor growth and increasing inequality in the world’s rich countries. Since 2007, employment rates have risen in only six of the 36 advanced economies, while youth unemployment has increased in a large majority of both established and emerging markets.

In the near term, the global crisis is likely to become worse as many governments, especially in advanced economies, prioritize fiscal austerity and tough labor-market reforms, even as such measures undermine livelihoods, incomes, and the social fabric.

Meanwhile, despite quantitative easing, many companies have limited access to credit, depressing investment and reducing job creation. Easy credit before the crisis encouraged over-investment in those sectors, such as housing, that were thought to be profitable. It is no surprise that the resulting excess capacity now discourages private investment in the real economy.

With inequality and unemployment higher, and incomes and domestic markets shrinking, everyone hopes to recover by exporting – an obviously impossible solution. Developing countries, long encouraged or even compelled to export and otherwise embrace globalization, have been abruptly told to switch course: to produce for the domestic market and to import more. The irony is that this advice comes after much of their former productive capacity has disappeared.

But, having suffered currency and capital-account crises with greater openness, many emerging-market economies still feel compelled to accumulate huge reserves to protect themselves in the face of greater global financial volatility. While financial globalization has not enhanced growth, it has exacerbated volatility and instability. Meanwhile, national “policy space” for economic recovery has shrunk since the crisis.

Public investment and basic social protection can help to turn this around, by creating millions of jobs. But, despite strong evidence to the contrary, the presumption that public investment crowds out private capital continues to discourage government-led economic-recovery efforts.

Historically, in fact, most advanced economies have lived with far higher fiscal deficits than they have today, and not only during wartime. Such deficits have financed strong, sustained, and inclusive growth not only in their own economies, but also abroad – as with the United States’ Marshall Plan, so central to European post-war reconstruction and recovery.

But now, because governments’ deployment of overwhelming financial resources to save selected private institutions deemed too big to fail caused sovereign debt to increase dramatically, officials have imposed fiscal austerity in deference to bond-market demands. Meanwhile, eurozone countries are constrained not only by this fiscal fetish, but also by their lack of exchange-rate flexibility.

Moreover, multilateral cooperation for global recovery has been disappointing since 2009 – the year of the G-20’s London and Pittsburgh summits, including the Global Jobs Pact, on which there has been little meaningful progress since. As a result, the past three years have witnessed little movement toward developing and implementing a strategy for strong, sustained, and inclusive recovery. Instead, we have seen creeping protectionism, and not only on the trade front.

So, how can the world escape a cul-de-sac constructed by the short-term perspective of financial markets and electoral politics?

Although inclusive multilateralism has been battered by various challenges, including its seeming messiness and slow progress, it remains the best option for various reasons. The United Nations system must be bolder, but powerful interests must also allow it to play a bigger role.

In 2009, recognizing that market forces alone will not generate the investments needed for climate change mitigation as well as affordable nutrition for all, UN Secretary-General Ban Ki-moon proposed a Global Green New Deal, including proposed cross-border, public-private partnerships, especially to generate renewable energy and increase sustainable food production.

Under recent French leadership, the International Monetary Fund, after decades of promoting economic – especially financial – liberalization and globalization, has become more careful, if not skeptical, of its own previous policy analyses, prescriptions, and operations. Likewise, recent initiatives by the International Labor Organization – such as Fair Globalization, the Global Jobs Pact, and the Social Protection Floor – are all directly relevant to addressing the current stasis.

Unique among international organizations, the ILO’s inclusion of both workers and employers as social partners in its tripartite governance allows it to help lead the undoubtedly difficult processes needed to ensure strong, sustained, and inclusive recovery and growth. So, perhaps more than ever in recent decades, inclusive multilateral institutions are on the same page. Now their efforts need the support that they deserve.

WASHINGTON, DC – Rearranging the deck chairs would not have saved the Titanic. Nor did the endless debates on the shape of the table in the Vietnam negotiations advance the effort to end that malign conflict. Nevertheless, many American presidents have successfully redesigned talks with adversaries in bold new ways to strengthen national security without war. Such boldness is now needed in the negotiations over Iran’s nuclear program.

In 1933, Franklin D. Roosevelt negotiated personally with Soviet Foreign Minister Maxim Litvinov to open diplomatic relations between the two countries. Dwight D. Eisenhower invited Nikita Khrushchev to the United States in 1959 to open the eyes of the first Soviet leader ever to visit America. The bilateral US-China talks in Warsaw in the 1960’s were fruitless until Richard M. Nixon and National Security Adviser Henry Kissinger opened a different, more direct discussion through the auspices of Pakistan.  

International negotiations with Iran over its nuclear program also need a new concept and broader agenda. The Istanbul meeting last month concluded on a positive note. Both sides decided to find a way to avoid the pattern of mutual recrimination and sterile exchanges. The door is now open to an initial agreement with modest goals.

But don’t count on a new era without some form of direct US-Iran discussions. The talks with the five permanent members of the United Nations Security Council plus Germany (P5+1) are formulaic, stagnant, and not likely to achieve any breakthrough on their own. The Iranians feel out-numbered by diverse participants with varying agendas. The US needs to reshape the environment to make it easier for Iran to compromise.

The US should press for bilateral talks. One lesson provided by former American presidents is the value of direct, high-level contacts with key adversaries. Of course, a face-to-face meeting between President Barack Obama and Ayatollah Ali Khamenei seems absurd to imagine – now. But could any meeting have seemed more absurd in 1969 than the 1972 meeting between Nixon and Mao Zedong? The US and Iran need to set a path toward broad bilateral discussions on worldviews, regional security, and plans to improve mutual understanding in order to minimize differences.

Even without direct US-Iran talks now, the current negotiations need reshaping. The P5+1 should continue to negotiate with Iran on its uranium-enrichment program, while the International Atomic Energy Agency should negotiate with Iran on strengthening the transparency of its nuclear program. The Iranians want to resolve their problems directly with the IAEA, and to avoid negotiating under the cloud of UN Security Council resolutions, which impose sanctions on Iran to force suspension of enrichment.

This situation suggests a phased approach. First, during the talks in Baghdad, the P5+1 might seek an early confidence-building agreement by which Iran voluntarily ceases enriching to 20% content in the U-235 fissile isotope and blends down or ships out their stockpile of such uranium, which is closer to weapons grade. They might also seek a standstill on the deep underground enrichment facility at Fordow, the deep underground enrichment facility near Qom, in exchange for provision of fuel rods for Iran’s research reactor and a freeze on some sanctions.

Second, the P5+1 could then agree to agree to some Iranian enrichment as an incentive for Iran to conclude a parallel agreement with the IAEA on greater transparency. These parallel steps would reshape the process to achieve a key US objective: ensuring that Iran abides by Khamenei’s own fatwa (religious decree) against nuclear weapons.

Third, both sides will need to outline the long-term objectives of the negotiations. As the IAEA presses Iran for agreements on greater transparency, Iran wants to know where such agreements might lead, particularly regarding sanctions.

Iranians claim that each time they move toward cooperation with the US, a new problem emerges to block improved relations. Iran wants to know which sanctions might be delayed, frozen, or lifted in exchange for current and future concessions, fearing that the US will continue to impose sanctions on human-rights, security, or other grounds.

The US, for its part, views Iran as a duplicitous and unreliable negotiator that is committed to nuclear weapons and unserious about talks. The time has come to test Iran’s intentions by reaching something like the two-phased agreements outlined here – a longer-term, step-by-step process with reciprocal actions, in which each side must give something to get what it needs.

Finally, even with step-by-step progress on Iran’s nuclear program, broader discussions are needed to address the many non-nuclear issues that threaten regional stability. There is currently no forum to discuss Afghanistan, Iraq, drug trafficking, Persian Gulf security, emergency communications to avoid accidental conflict, and the sources of deep distrust and misunderstanding.

Some of these discussions might involve representatives of states that are not part of the P5+1, including governments that have closer relations with Iran. To organize discussion of these broader issues, the US and others should explore the possibility of appointing a special envoy – perhaps a former Chief of State under UN auspices – to engage Iran in new ways.

If Obama were to take the lead in reshaping the setting and the process by which the US and others talk with Iran, progress could become easier. The Istanbul talks opened the door to an initial – if incremental – breakthrough agreement. The US now has an opportunity to establish new ways to explore common ground and reach a more durable political solution.

NEW HAVEN – At this time of year, at graduation ceremonies in America and elsewhere, those about to leave university often hear some final words of advice before receiving their diplomas. To those interested in pursuing careers in finance – or related careers in insurance, accounting, auditing, law, or corporate management – I submit the following address:

Best of luck to you as you leave the academy for your chosen professions in finance. Over the course of your careers, Wall Street and its kindred institutions will need you. Your training in financial theory, economics, mathematics, and statistics will serve you well. But your lessons in history, philosophy, and literature will be just as important, because it is vital not only that you have the right tools, but also that you never lose sight of the purposes and overriding social goals of finance.

Unless you have been studying at the bottom of the ocean, you know that the financial sector has come under severe criticism – much of it justified – for thrusting the world economy into its worst crisis since the Great Depression. And you need only check in with some of your classmates who have populated the Occupy movements around the world to sense the widespread resentment of financiers and the top 1% of income earners to whom they largely cater (and often belong).

While some of this criticism may be over-stated or misplaced, it nonetheless underscores the need to reform financial institutions and practices. Finance has long been central to thriving market democracies, which is why its current problems need to be addressed. With your improved sense of our interconnectedness and diverse needs, you can do that. Indeed, it is the real professional challenge ahead of you, and you should embrace it as an opportunity.

Young finance professionals need to familiarize themselves with the history of banking, and recognize that it is at its best when it serves ever-broadening spheres of society. Here, the savings-bank movement in the United Kingdom and Europe in the nineteenth century, and the microfinance movement pioneered by the Grameen Bank in Bangladesh in the twentieth century, comes to mind. Today, the best way forward is to update financial and communications technology to offer a full array of enlightened banking services to the lower middle class and the poor.

Graduates going into mortgage banking are faced with a different, but equally vital, challenge: to design new, more flexible loans that will better help homeowners to weather the kind of economic turbulence that has buried millions of people today in debt.

Young investment bankers, for their part, have a great opportunity to devise more participatory forms of venture capital – embodied in the new crowd-funding Web sites – to spur the growth of innovative new small businesses. Meanwhile, opportunities will abound for rookie insurance professionals to devise new ways to hedge risks that real people worry about, and that really matter – those involving their jobs, livelihoods, and home values.

Beyond investment banks and brokerage houses, modern finance has a public and governmental dimension, which clearly needs reinventing in the wake of the recent financial crisis. Setting the rules of the game for a robust, socially useful financial sector has never been more important. Recent graduates are needed in legislative and administrative agencies to analyze the legal infrastructure of finance, and regulate it so that it produces the greatest results for society.

A new generation of political leaders needs to understand the importance of financial literacy and find ways to supply citizens with the legal and financial advice that they need. Meanwhile, economic policymakers face the great challenge of designing new financial institutions, such as pension systems and public entitlements based on the solid grounding of intergenerational risk-sharing.

Those of you deciding to pursue careers as economists and finance scholars need to develop a better understanding of asset bubbles – and better ways to communicate this understanding to the finance profession and to the public. As much as Wall Street had a hand in the current crisis, it began as a broadly held belief that housing prices could not fall – a belief that fueled a full-blown social contagion. Learning how to spot such bubbles and deal with them before they infect entire economies will be a major challenge for the next generation of finance scholars.

Equipped with sophisticated financial ideas ranging from the capital asset pricing model to intricate options-pricing formulas, you are certainly and justifiably interested in building materially rewarding careers. There is no shame in this, and your financial success will reflect to a large degree your effectiveness in producing strong results for the firms that employ you. But, however imperceptibly, the rewards for success on Wall Street, and in finance more generally, are changing, just as the definition of finance must change if is to reclaim its stature in society and the trust of citizens and leaders.

Finance, at its best, does not merely manage risk, but also acts as the steward of society’s assets and an advocate of its deepest goals. Beyond compensation, the next generation of finance professionals will be paid its truest rewards in the satisfaction that comes with the gains made in democratizing finance – extending its benefits into corners of society where they are most needed. This is a new challenge for a new generation, and will require all of the imagination and skill that you can bring to bear.

Good luck in reinventing finance. The world needs you to succeed.

CHICAGO – Turkey has recently been at the forefront of international economic and political debates. On the one hand, despite the economic crisis engulfing neighboring Europe, Turkey remains the world’s second-fastest growing economy, after China. On the other hand, there is almost no issue on the global agenda – from Iraq and Afghanistan to Somalia, Iran, and the Arab Spring, and from sustainable development to a dialogue among civilizations – on which Turkey is not playing a visible role.

This is a rather new phenomenon. Until a decade ago, Turkey was regarded as no more than a staunch NATO ally. That began to change in 2002, when an era of political stability dawned, giving rise to a vision for a stronger Turkey – and a firm commitment to realizing that vision.

To this end, Turkey’s governments since 2002 implemented bold economic reforms that paved the way for sustainable growth and provided a firewall against the financial crisis that hit in 2008. As a result, in less than a decade, GDP has tripled, making Turkey the world’s 16th largest economy. Moreover, the country benefits from strong public finances, prudent monetary policy, sustainable debt dynamics, a sound banking system, and well-functioning credit markets.

At the same time, we expanded the scope of individual rights, which had long been subordinated to security concerns. We streamlined civil-military relations, guaranteed social and cultural rights, and attended to the problems of ethnic and religious minorities. These reforms transformed Turkey into a vibrant democracy and a more stable society, at peace with itself and able to view its external environment in a different light.

Quite simply, we stopped viewing our geography and history as a curse or disadvantage. On the contrary, we began to regard our location at the crossroads of Europe, Asia, and the Middle East as an opportunity to interact simultaneously with multiple players.

As a result, we began to reach out to countries in our neighborhood and beyond. We tried to expand political dialogue, enhance economic interdependence, and strengthen cultural and social understanding. And, while ten years is too short for a definitive assessment of such an ambitious policy, we have undoubtedly covered considerable ground. For example, we have quadrupled our trade volume just with our neighbors.

On several occasions, we have also been instrumental in facilitating peace and reconciliation. But, what is more important, Turkey has become a model of success that many countries around us now seek to emulate.

And yet, until a year or two ago, some political pundits were asking, “Who lost Turkey?” or “Whither Turkey?” – the assumption being that Turkey had shifted its foreign-policy axis away from the West. In fact, Turkey’s external orientation has remained constant, because it rests on the values that we share with the free world. What has changed is our increased assertiveness in our efforts to ensure greater stability and human welfare in our region, evident in our advocacy of freedom, democracy, and accountability not only for ourselves, but also for others.

This approach has been reflected in the Arab Spring, which Turkey ardently supported from the outset. We have not hesitated in siding with those fighting for their rights and dignity. Indeed, in countries like Tunisia, Egypt, Libya, and Yemen, which are now attempting to institutionalize change, Turkey is their most active partner, sharing our own experience and providing tangible assistance in the form of economic cooperation and political capacity building.

In Syria, on the other hand, the revolution has not yet come to fruition, owing to the regime’s brutal repression of its opponents. Every day, scores of people there die in pursuit of dignity. Turkey is doing all that it can to alleviate the Syrian people’s suffering. Unfortunately, the international community as a whole has so far performed poorly in providing an effective response to the crisis.

Turkey’s position on Iran’s nuclear program has been similarly clear: we are categorically opposed to the presence of weapons of mass destruction in our region. Attempts to develop or acquire WMDs might well trigger a regional arms race, leading to further instability and threatening international peace and security. That is why we have always called for the establishment of a WMD-free zone in the Middle East, including both Iran and Israel.

We support Iran’s right to use nuclear energy for peaceful purposes. But Iran’s program must be transparent, and its leaders must assure the international community of its non-military nature. The key is to close the confidence gap and pave the way for meaningful dialogue. In April, we hosted the inaugural round of revived talks between the international community and Iran.

Let us be clear: there is no military solution to this problem. Military intervention would merely further complicate the issue, while creating new layers of conflict in our region and beyond.

In this and other matters, Turkey strives to act as a “virtuous power,” which requires us to align our national interests with values such as justice, democracy, and human dignity, and to achieve our foreign-policy goals through mutual cooperation rather than coercion.

Effective multilateralism is a key facet of this vision. Turkey served as a member of the United Nations Security Council in 2009-2010, and is now seeking another term in 2015-2016. Given the crucial importance of developments in our part of the world, Turkey’s contribution to the Council’s work promises to be highly valuable.

In 2015, moreover, we will assume the presidency of the G-20, and we are committed to using our means and capabilities to make it a more effective organ of global governance.

Turkey’s internal transformation over the past decade has placed it in an ideal position to benefit the region – and thus the global community. While we have accomplished much already, more is required of us. Given the challenges of our neighborhood, and the region’s central role in global affairs, Turkey will not refrain from taking on new responsibilities.

WASHINGTON, DC – The creation of the euro just over a decade ago was a courageous and unique experiment. Today, the outcome – whether the euro will survive, and whether the Europeans are right to keep it – is very much in doubt. But, if the eurozone does survive, it promises great advantages for member countries – and perhaps for the world.

The euro is an ultra-fixed currency among members: participating countries locked themselves into an initial exchange rate vis-à-vis their pre-existing currencies and then threw the keys into the long grass. Nowadays, an increasing number of Europeans are combing that grass, quietly looking for those keys.

The euro shares important features with versions of the old gold standard, under which countries fixed their exchange rates relative to each other by setting the price at which domestic currency could be redeemed in gold. Today, some people espouse the view – often loudly – that the gold standard was synonymous with economic and financial stability. But that is completely at odds with the historical record: the era of the gold standard is replete with boom-bust episodes fueled by over-borrowing by governments, firms, individuals, or all of the above.

There are three differences between the euro and the gold standard – none of which is particularly reassuring at this moment.

First, the gold standard’s central premise was a finite quantity of gold in the world; more of it cannot be created or discovered, at least not quickly. By contrast, the European Central Bank can create more euros if so desired. Countries cannot run out of liquidity, because the ECB can always provide more cash.

But governments and investors know this, and the result has been much higher debt-to-GDP ratios than would have been possible under the gold standard. The eurozone as a whole has a debt-to-GDP ratio of 90%, which is high by any standard.

Such debt levels are sustainable as long as investors continue to assume that another bailout is just around the corner. But if the ECB is threatening to cut off support – for example, because a government will not comply with what the Germans regard as good economic policy – the whole house of cards can come tumbling down.

Second, financial markets have become huge relative to anything seen under the gold standard. European banks could bulk up in large part because it was assumed that their respective governments backed them. Not only are these banks now large relative to some national economies, but the quality of government credit is now in question across the eurozone periphery – up to and including Italy. The term “risk-free asset” has become an oxymoron in contemporary Europe.

European banks have been operating on a great deal of debt and very little shareholder capital – the essential buffer against potential losses. Any shock to sovereign debt or further downturn in local economies will be transmitted through an overleveraged and undercapitalized banking system to other European countries and – quite possibly – elsewhere, including the United States.

Finally, for all the talk today of the discipline that the gold standard supposedly provided, countries that adhered to it regularly suspended convertibility – meaning that the domestic currency could no longer be converted freely into gold. But today’s Europeans have no domestic currency – just the euro. If any country – for example, Greece – left the euro, all contracts in that country would have to be rewritten. The disruption, particularly to credit, would be profound.

The proper functioning of the gold standard required a high degree of flexibility in wages and prices. If exchange rates cannot depreciate, wages and prices need to fall when a country has an unsustainable current-account deficit. But, as peripheral Europe can now attest, this is a cumbersome, painful, and politically unpopular form of economic adjustment. Expect the backlash against it to grow in the months and years ahead.

The news focus today is on how hard it is for the eurozone periphery to adjust and return to growth, owing to the combination of high public debt and actual or perceived austerity measures. But there is a flip side to the problem: capital is flowing to Germany as the regional safe haven, making credit more readily available there. The dynamics of adjustment within the eurozone exacerbate the underlying imbalances – Germany is becoming more competitive while the periphery remains uncompetitive.

The recent Greek elections have brought more radical parties to the fore. Alexis Tsipras, the head of the Coalition of the Radical Left has a valid point: “internal devaluation” – cutting wages and prices – is failing as a strategy. His alternative appears to be to abandon the euro. If Greece can’t do better than this, he argues, then it should leave.

But this is not about Greece any longer. Italy, Spain, Portugal, and even Ireland face the same issues, but are at an earlier stage in the backlash. Unemployment is rising, their economies are not becoming more competitive, and the interest rates on their debt continue to rise. These countries may eventually decide to leave. And, even if they don’t make that choice, fear of such exits can easily become self-fulfilling.

The euro system was designed to deliver prosperity and stability for all. It has clearly failed for some countries, and it may fail for many. Severe mismanagement by European politicians has caused damage that will last for decades.

Perhaps a stronger fiscal union, a central ministry of finance, and debt sharing would reduce the difficulties and imbalances enough to allow the euro to survive. Perhaps adjustment will start to work just in time.

There is a lot of shouting in the jury room. Expect a verdict soon.

PARIS – The euro, many now believe, will not survive a failed political class in Greece or escalating levels of unemployment in Spain: just wait another few months, they say, the European Union’s irresistible collapse has started.

Dark prophecies are often wrong, but they may also become self-fulfilling. Let’s be honest: playing Cassandra nowadays is not only tempting in a media world where “good news is no news”; it actually seems more justified than ever. For the EU, the situation has never appeared more serious.

It is precisely at this critical moment that it is essential to re-inject hope and, above all, common sense into the equation. So here are ten good reasons to believe in Europe – ten rational arguments to convince pessimistic analysts, and worried investors alike, that it is highly premature to bury the euro and the EU altogether.

The first reason for hope is that statesmanship is returning to Europe, even if in homeopathic doses. It is too early to predict the impact of François Hollande’s election as President of France. But, in Italy, one man, Mario Monti, is already making a difference.

Of course, no one elected Monti, and his position is fragile and already contested, but there is a positive near-consensus that has allowed him to launch long-overdue structural reforms. It is too early to say how long this consensus will last, and what changes it will bring. But Italy, a country that under Silvio’s Berlusconi’s cavalier rule was a source of despair, has turned into a source of real, if fragile, optimism.

A second reason to believe in Europe is that with statesmanship comes progress in governance. Monti and Hollande have both appointed women to key ministerial positions. Marginalized for so long, women bring an appetite for success that will benefit Europe.

Third, European public opinion has, at last, fully comprehended the gravity of the crisis. Nothing could be further from the truth than the claim that Europe and Europeans, with the possible exception of the Greeks, are in denial. Without lucidity born of despair, Monti would never have come to power in Italy.

In France, too, citizens have no illusions. Their vote for Hollande was a vote against Sarkozy, not against austerity. They are convinced, according to recently published public-opinion polls, that their new president will not keep some of his “untenable promises,” and they seem to accept this as inevitable.

The fourth reason for hope is linked to Europe’s creativity. Europe is not condemned to be a museum of its own past. Tourism is important, of course, and from that standpoint Europe’s diversity is a unique source of attractiveness. But this diversity is also a source of inventiveness. From German cars to French luxury goods, European industrial competitiveness should not be underestimated.

The moment when Europe truly believes in itself, the way Germany does, and combines strategic long-term planning with well allocated R&D investments, will make all the difference. Indeed, in certain key fields, Europe possesses a globally recognized tradition of excellence linked to a very deep culture of quality.

The fifth source of optimism is slightly paradoxical. Nationalist excesses have tended to lead Europe to catastrophic wars. But the return of nationalist sentiment within Europe today creates a sense of emulation and competition, which proved instrumental in the rise of Asia yesterday. Koreans, Chinese, and Taiwanese wanted to do as well as Japan. In the same way, the moment will soon come when the French want to do as well as Germany.

The sixth reason is linked to the very nature of Europe’s political system. Churchill’s famous adage that democracy is the worst political system, with the exception of all the others, has been borne out across the continent. More than 80% of French citizens voted in the presidential election. Watching on their televisions the solemn, dignified, peaceful, and transparent transfer of power from the president they had defeated to the president they had elected, French citizens could only feel good about themselves and privileged to live in a democratic state. Europeans may be confused, inefficient, and slow to take decisions, but democracy still constitutes a wall of stability against economic and other uncertainties.

The seventh reason to believe in Europe is linked to the universalism of its message and languages. Few people dream of becoming Chinese, or of learning its various languages other than Mandarin. By contrast, English, Spanish, French, and, increasingly, German transcend national boundaries.

Beyond universalism comes the eighth factor supporting the EU’s survival: multiculturalism. It is a disputed model, but multiculturalism is more a source of strength than of weakness. The continent’s fusion of culture makes its people richer rather than poorer.

The ninth reason for hope stems from the EU’s new and upcoming members. Poland, a country that belongs to “New Europe,” is repaying the EU with a legitimacy that it had gained from Europe during its post-communist transition. And the entrance of Croatia, followed by Montenegro and a few other Balkan countries, could compensate for the departure of Greece (should it come to that for the Greeks).

Finally, and most important, Europe and the world have no better alternative. The Greek crisis may be forcing Europe to move towards greater integration, with or without Greece. The German philosopher Jürgen Habermas speaks of a “transformational reality” – a complex word for a simple reality: divided we fall, whereas united, in our own complex manner, we may strive for “greatness” in the best sense.

Investors, of course, are hedging their bets. Having ventured successfully into emerging non-democratic countries whose frailty they are starting to fear, some, out of prudence, are starting to rediscover Europe. They may well be the wise ones.

LONDON – Is China poised to become the world’s next superpower? This question is increasingly asked as China’s economic growth surges ahead at more than 8% a year, while the developed world remains mired in recession or near-recession. China is already the world’s second largest economy, and will be the largest in 2017. And its military spending is racing ahead of its GDP growth.

The question is reasonable enough if we don’t give it an American twist. To the American mind, there can be only one superpower, so China’s rise will automatically be at the expense of the United States. Indeed, for many in the US, China represents an existential challenge.

This is way over the top. In fact, the existence of a single superpower is highly abnormal, and was brought about only by the unexpected collapse of the Soviet Union in 1991. The normal situation is one of coexistence, sometimes peaceful sometimes warlike, between several great powers.

For example, Great Britain, whose place the US is often said to have taken, was never a “superpower” in the American sense. Despite its far-flung empire and naval supremacy, nineteenth-century Britain could never have won a war against France, Germany, or Russia without allies. Britain was, rather, a world power – one of many historical empires distinguished from lesser powers by the geographic scope of their influence and interests.  

The sensible question, then, is not whether China will replace the US, but whether it will start to acquire some of the attributes of a world power, particularly a sense of responsibility for global order.

Even posed in this more modest way, the question does not admit of a clear answer. The first problem is China’s economy, so dynamic on the surface, but so rickety underneath.

The analyst Chi Lo lucidly presents a picture of macro success alongside micro failure. The huge stimulus of RMB4 trillion ($586 billion) in November 2008, mostly poured into loss-making state-owned enterprises via directed bank lending, sustained China’s growth in the face of global recession. But the price was an increasingly serious misallocation of capital, resulting in growing portfolios of bad loans, while excessive Chinese household savings have inflated real-estate bubbles. Moreover, Chi argues that the crisis of 2008 shattered China’s export-led growth model, owing to prolonged impairment of demand in the advanced countries.

China now urgently needs to rebalance its economy by shifting from public investment and exports towards public and private consumption. In the short run, some of its savings need to be invested in real assets abroad, and not just parked in US Treasuries. But, in the longer term, Chinese households’ excessive propensity to save must be reduced by developing a social safety net and consumer credit instruments.

Moreover, to be a world economic power, China requires a currency in which foreigners want to invest. That means introducing full convertibility and creating a deep and liquid financial system, a stock market for raising capital, and a market rate of interest for loans. And, while China has talked of “internationalizing” the renminbi, it has done little so far. “Meanwhile,” writes Chi, “the dollar is still supported by the strong US political relations with most of the world’s largest foreign-reserve-holding countries.” Japan, South Korea, Saudi Arabia, Kuwait, Qatar, and the United Arab Emirates all shelter under the US military umbrella.

The second problem is one of political values. China’s further “ascent” will depend on dismantling such classic communist policy icons as public-asset ownership, population control, and financial repression. The question remains how far these reforms will be allowed to go before they challenge the Communist Party’s political monopoly, guaranteed by the 1978 constitution.

Two important cultural values underpin China’s political system. The first is the hierarchical and familial character of Chinese political thought. Chinese philosophers acknowledge the value of spontaneity, but within a strictly ordered world in which people know their place. As the Analects of Confucius puts it: “Let the ruler be a ruler, the subject a subject, a father a father, and a son a son.”

There is also very little belief in the sanctity of human life: Buddhism holds that there is no difference between humans and animals and plants. A pledge to protect human rights was written into the Chinese constitution in 2004; but, as the recent case of the blind dissident Chen Guangcheng illustrates, this is mostly a dead letter. Similarly, private property ranks below collective property.
Then there is the Confucian doctrine of the “mandate of heaven,” by which political rule is legitimized. Today, the mandate of Marxism has taken its place, but neither has any room for a mandate of the people. Ambivalence about the source of legitimate government is not only a major obstacle to democratization, but is also a potential source of political instability.
These historical legacies limit the extent to which China will be able to share in global leadership, which requires some degree of compatibility between Chinese and Western values. The West claims that its values are universal, and the US and Europe will not cease pressing those values on China. It is hard to see this process going into reverse, with China starting to export its own values.

China has a choice: it can either accept Western values, or it can try to carve out an East Asian sphere to insulate itself from them. The latter course would provoke conflict not only with the US, but also with other Asian powers, particularly Japan and India. China’s best possible future thus probably lies in accepting Western norms while trying to flavor them with “Chinese characteristics.”

But neither choice is a scenario for China “replacing” the US. Nor, I think, is this what China wants. Its goal is respect, not dominance.

PRINCETON – Next week, NATO’s 28 members will meet in Chicago for their annual summit. Sixty-two years after the North Atlantic Treaty was signed, binding the United States, Canada, and ten European states to consider an attack on one an attack on all, NATO is transforming itself into a twenty-first-century global security organization. The result will be a safer world.

In 1949, the world was rapidly dividing into two principle political-military blocs, East and West, alongside a large “non-aligned movement.” NATO faced off against the Warsaw Pact, created by the Soviet Union and its allies in 1955. Within both blocs, smaller powers clustered around the superpower. No flexibility existed within either bloc for smaller groups of members to deploy alliance assets.

Today, NATO is becoming, in the words of its secretary-general, Anders Fogh Rasmussen, “a hub of a network of security partnerships and a center for consultation on global security issues.” It is a “globally connected institution,” with more than 40 individual country partners and growing ties to other international organizations.

Indeed, the country partners include all of Europe’s non-NATO countries, such as Austria, Switzerland, Finland, and Sweden, and aspiring and possible NATO members such as Bosnia, Serbia, Macedonia, Ukraine, Belarus, and even Russia. Virtually all of the Central Asian countries – from Turkmenistan to Kazakhstan, as well as Armenia, Azerbaijan, Afghanistan, and Pakistan – are partners, as is the entire Maghreb, from Morocco to Egypt, as well as Israel, Jordan, Iraq, Bahrain, Qatar, Kuwait, and the United Arab Emirates. Finally, Pacific partners include Japan, South Korea, Australia, New Zealand, and Mongolia.

On the organizational side, NATO describes itself as having developed “close working relations” with the United Nations, the European Union, and the Organization for Security and Cooperation in Europe. It also collaborates regularly with the African Union, the International Committee of the Red Cross, the International Organization for Migration, the World Bank, the International Civil Aviation Organization, and the Organization for the Prohibition of Chemical Weapons.

If one draws links radiating outward from NATO to all of these different countries and organizations, the result is a security network that has multiple hubs and clusters – much like a map of the Internet or of planets and galaxies. This world is no longer unipolar, bipolar, or even multipolar, because the actors that matter are not single states but groups of states that are more or less densely connected. It is a multi-hub security network, in which the hubs are regional organizations of different sizes and strengths.

This structural shift has enormous practical significance. For starters, it means that not only NATO’s military resources, but also its human capital and practical knowledge in combating many different kinds of threats are available globally. NATO has created a Comprehensive Crisis and Operations Management Center that brings together civilian and military expertise on crisis identification, planning, operations, reconstruction, and stabilization capabilities in ways that are explicitly designed to connect NATO headquarters in Europe to “the networked world.”

Second, NATO’s own identity is becoming that of an alliance that exists to empower – to offer assistance and partnership – as much as to overpower. NATO is no longer just a hammer; it is an entire toolbox of security options. These options include developing counter-networks to meet networked security threats such as terrorism and proliferation of nuclear, chemical, or biological materials, as well as highly decentralized threats such as piracy. As a result, when a crisis like the war in East Timor in 1999 or last year’s political stalemate in Côte d’Ivoire arises, NATO can backstop whichever country or group of countries chooses to take the lead in carrying out a UN mandate.

NATO members themselves also have much more flexibility to draw on NATO’s collective assets. Even skeptics of NATO expansion and operations like the intervention in Libya now recognize that joint operations by member countries, operating under a UN mandate and in conjunction with regional partners, is likely to be a model for the future. As General Brent Scowcroft, National Security Adviser for President George H.W. Bush, observed recently, the UN Charter originally envisioned a standing military force to enforce Security Council resolutions – a vision that the NATO partner model might ultimately realize.

Power in a network flows from connectedness, or what network theorists call “centrality.” The most powerful member of a network is the node that has the most connections to others, which means that a node can increase its power not only by adding connections directly, but also by increasing the connectedness of nearby nodes.

In other words, the US can increase its own power both by connecting to other NATO members (and then ensuring that NATO is connected to as many other countries and organizations as possible) and by increasing the connectedness of those other countries and organizations. If NATO connects with the African Union, for example, and increases the AU’s connectedness, then both NATO and the AU become more central to the network and hence more powerful in terms of their ability to exercise influence and marshal resources.

The logic of centrality as a source of power creates a virtuous circle, in which members of a network gain advantage by bringing more members into the network and connecting more densely to them. That is exactly the logic behind NATO’s transformation.

The immediate topic on the agenda in Chicago next week will be getting NATO forces out of Afghanistan. But the longer-term subject will be getting as many countries as possible into the global NATO security network.

NEW YORK – The compelling drama of former Chongqing Communist Party chief Bo Xilai’s ouster amid allegations of corruption and murder, and of blind Chinese human-rights advocate Chen Guangcheng’s dash to safety in the US Embassy in Beijing, are more than just fascinating narratives of venality and courage. Unless China can purge the thousands of corrupt Party leaders like Bo, and empower people – like those Chen represents – who have been left behind or harmed by rapid growth, its economy will increasingly suffer.

Like the Asian Tiger economies before it, China has excelled in the first phase of capitalist economic growth, benefiting from massive infusions of capital, low-cost labor, intellectual-property theft, and centralized planning. And, like many of them, China is now facing a “middle-income trap”: as wages rise, its low-end manufacturing is losing global competitiveness while government policies, endemic corruption, and dominant state-owned enterprises are stifling the type of private-sector innovation that China needs most to generate products and services with higher added value.

China’s leaders understand this, which is why the government’s 12th Five-Year Plan calls for a gradual opening up of the Chinese economy. Likewise, a Chinese government think tank worked with the World Bank to produce the China 2030report, which outlines the structural reforms needed to strengthen the foundations of the country’s market-based economy and create a climate of open innovation.

But if China’s national imperative today is reform, the greatest threat to that goal is the massive influence and institutionalized corruption of the country’s entrenched elites. For years, senior Chinese officials and their families have received a cut of countless major investments throughout China. They and their families have become multimillionaires by exploiting the close association of business and politics, as well their strong links with China’s state-owned enterprises.

The resulting rise in inequality has been exacerbated by China’s capital controls and mandated low interest rates on savings. For lack of other options, poor people put their money in banks which then lend to more privileged people to fund state-owned enterprises or much higher-yielding real-estate investments.

This system worked to drive overall economic growth and financial rewards in the first phase of China’s post-reform growth, but the incomes of ordinary Chinese have stagnated over the past decade, their interests have been neglected, capital has been misallocated, and major negative environmental and social side effects have emerged. Now those who have benefited most from the current system are blocking badly needed reforms.

For example, years of imbalanced incentives have led China to overbuild premium residential real-estate, which should cause prices to fall dramatically. But, although the government is trying to take some of the air out of the market, the authorities cannot easily take the more aggressive action that is required, because Chinese officials and other elites store so much of their wealth in real estate, which also comprises much of the collateral of state-connected banks, Similarly, although state-owned enterprises are sucking too much oxygen out of China’s economy, reforming them would require taking on China’s most powerful business and government leaders.

This is why the Chinese government’s dance around the Bo scandal has been so complicated. Bo may have lost an internal political struggle, and may have crossed a line after the murder of British businessman Neil Heywood, for which Bo’s wife is under arrest; but vilifying him is a double-edged sword for the government. On one hand, the authorities need to pursue him aggressively to justify the purge of someone who was so recently lauded. On the other hand, many of the accusations against Bo could be leveled at an extremely large number of senior officials across China who, like Bo, have amassed multimillion-dollar family fortunes.

In highlighting Bo’s misdeeds, the Party is trying to demonstrate that it alone can and should be responsible for addressing official corruption. But given that the people who have benefited so much from the current system are unlikely to clean it up, the only other way to generate reform would be to empower the people getting the short end of the stick – people like Chen and those he has helped.

The crackdown on Chen for representing villagers who have been abused by the authorities follows the same pattern as the silencing of parents who protested shoddy school construction after the 2008 Sichuan earthquake, and of opponents of the environmentally damaging Three Gorges Dam. If China is serious about reform, it will need armies of people like these, fighting for their rights, in order to balance the overwhelming political power of its entrenched elites.

China’s reform process can succeed only if it is pushed from the top and the bottom. The Party needs to find every possible way to get rid of the Bo’s in its midst. Instead of threatening people like Chen, the Party should give them recognition and support. None of this will be easy, but the future of China’s economy depends on it.