Post-Conflict Economic Transitioning and the War on Terror -- Challenges and Solutions

September 17, 2003
By Stephen Boyko and Aron Gottesman

The liberation of failed states is a key element of the war on terror. The immediate objective of these campaigns is to eliminate omnipresent security risks associated with failed states. A related objective, addressed in this paper, is to stimulate post-conflict economic development, so as to create environments in which terrorists have difficulty operating and retaining support.

Unfortunately, nation building is very difficult and has a less than desirable record. The fluidity of nation-building events can render reality contextual, as policymakers strive to reconcile suboptimalities through attributing them to “bad people” that provide inappropriate or insufficient governance or “bad laws” that are irrelevant to cultural mores or are prohibitively expensive.

For example, few countries in the former Soviet Union have developed into economically viable and democratic states. Slower-than-expected economic development in some Newly Independent States (NIS) is attributable to a misperception of the former Soviet Union’s governance structure. “Soviet Inc.” was an unprofitable firm, not an inefficient market. Employing market protocols of regulation and infrastructure to remedy firm maladies added complexity to the preexisting Byzantine structure that thwarted commercial activity in normative markets. These results occurred despite the expenditure of untold billions and the participation of numerous well-intentioned and well-qualified consultants from the top echelons of government agencies, international actors (e.g. World Bank, IMF, USAID, DFID), and prestigious business schools.

The inability to produce economic viability suggests that attributing nation-building disappointments to perceived apathetic or malevolent characteristics of the liberated populaces is an error. As well, we should not automatically blame corruption, the skimming of resources (asset stripping and transfer pricing) and a spiriting off of these resources to other economies for the benefit of a well positioned few. Corruption tends to flourish when incentives are in the wrong place and unevenly applied. Instead of manufacturing excuses, it is incumbent on policymakers to diagnose the flaws in their previous, current, and proposed nation-building efforts, and cultivate solutions.

In our opinion, transitioning economies can be categorized in terms of the incentives and commands that mold the behavior of the populace. Incentives are the potential for a net benefit (i.e., profit). Commands are the package of standards and rules that an administrating body enforces, which reflexively alters behavior in pursuit of profit. Standards and rules are divergent concepts. An inaccurate and/or an inappropriate mixture of the two can cause the nation-building experiment to fail in the post-conflict “laboratory.”

What is the difference between standards and rules? Standards are prospective societal policies. They are systemic prescriptions that enable the realization of industry norms relative to cultural values. For example, capital market standards in developed countries are specified in terms of fairness, liquidity, integration, transparency, and efficiency. Rules, on the other hand, are the retrospective codification of best-practice procedures that define operational efficiency.

If standards are too low, the transitioning economy develops balkanized markets where products are overpriced due to excessive “due diligence” and labor costs. If there are too few rules (i.e., best practices), the economy is, effectively, an offshore market that provides unregulated services and permits nontransparent activities. When standards are too high and there are too many rules, the economy develops markets that are controlled by unresponsive oligopolies that compete through excessive rules (regulatory related corruption). In such economies, actors unable or unwilling to bear the cost of the excessive rules are forced either underground or offshore into unregulated markets that produce nonstandard products or are relegated to a balkanized scale.

None of the above scenarios are desirable. Economic transitioning can be stalled by the high transaction costs that result from excessive due diligence, labor, and/or regulatory burden. This results in the governance equivalent of Heisenburg’s Uncertainty Principle that posits that the simultaneous measurement of two conjugate variables—such as regulatory commands and the level of commercial activity—entails limitations on the precision of the management for each variable. The more demanding regulatory commands are for a given level of economic activity, the more imprecise the management of commercial activity due to transactional transference to the “shadow economy” of offshore and underground markets.

Excessive and/or mismatched regulation constrains commercial activity and inhibits the formation of economically viable states in which terrorists have difficulty retaining support. Nontransparency hides the activities of the unholy alliance between terrorists and ordinary criminals. This creates a governance disadvantage where police and military are forced to function in the other’s capacity. The objective of the policymaker is to find the middle ground: the equilibrium level of standards and rules that avoids excessive regulatory burden, due diligence, and labor, as well as the nontransparency of underground or offshore markets.

Hence, the key challenge faced by policymakers is identifying the appropriate levels of standards and rules relative to incentives. In our opinion, nation-building difficulties occur because policymakers often prescribe mature, Western metrics for developing nations that constrain commercial activity and inhibits economic development. It is difficult for “best practices” to develop in the absence of activity. We believe that policymakers “overdose” liberated states with rules and standards due to their focus on firms that are “bought” at the expense of small-to-medium enterprises (SMEs) that are “sold.” We designate a firm as “bought” if it is earnings-driven. The existence of positive cash flow allows the firm to be priced using financial analyst techniques that utilize financial data such as cash flows, earnings, and dividends. Earnings information also allows analysts to quantify and manage risk. We designate a firm as “sold” if it is event-driven (i.e., new technology in search of a new contract). The valuation of such firms is a function of its corporate mission, percentage of market share, or price-to-sales ratio. These firms face uncertainty; unlike risk, uncertainty cannot be quantified or managed. “Sold” firms only grow to be “bought” firms following a critical corporate event that enables them to generate positive cash flow. This requires an unfettered economic environment that enables commercial activity to take place.

We believe compliance commands (standards and rules) that apply to “bought” firms are inappropriate for “sold” firms. While “bought” firms can bear the burden of regulation, SMEs that are typically “sold” frequently cannot. Imposing Western commands appropriate for “bought” firms on economies composed primarily of “sold” firms leads to a governance overdose and unintended consequences. Thus, the systemic predictability that policy makers seek is often thwarted by increased compliance cost and capital “burn rate.” This retards the likelihood of achieving positive cash flow and commercial viability making the economy more uncertain.

So how should policymakers set commands relative to incentives to permit successful post-conflict economic transitioning? In our opinion, success is most likely when policymakers apply governance to “sold” firms that is distinct from the governance of “bought” firms. The first step is identification of markets as consisting of firms that are “sold” rather than “bought.” To facilitate such identification, we propose a new diagnostic model that we designate the GAAMA model. GAAMA is an acronym for the characteristics that describe markets consisting of “sold” firms, and for which distinct governance should be considered: Global, Asynchronous, Asymmetrical, Market Activity. A market should be considered for distinct governance if its activities are global: widespread in terms of mass and materiality. The market can be classified as consisting of “sold” firms if information arrival is asynchronous and asymmetrical. Information in such markets is asynchronous due to the reliance on questionable event data instead of earnings data, which suggests that investors do not receive timely information. This information is also asymmetrical, due to unequal access to information and uncertainty regarding the accuracy of information.

Once the market type is identified, policymakers can determine the appropriate mixture of standards and rules. The mixture of standards and rules that supports economic growth in a market consisting of “bought” firms may be an overdose level for transitioning economies with GAAMA markets consisting of “sold” firms. This overdose can stall the formation of economically viable and democratic states, and can result in the formation of underground markets. Conversely, correct diagnosis of an economy as consisting of GAAMA markets permits the correct prescription of standards and rules, setting the country up for a successful economic transition.

Failed states and underground markets are the environment in which terrorists most easily operate and draw support; hence successful economic transitioning is a nation-building precondition. The Danish philosopher, Soren Kierkegaard, stated that life is lived by looking forward, but learned by looking backwards. Endemic nation-building difficulties need not foretell the future.

Stephen A. Boyko is President of Global Market Thoughtware, Inc., an international consulting company. He has over twenty-five years of business and financial experience in a broad range of financial service industries.  Aron A. Gottesman, Ph.D., is an Assistant Professor of Finance at the Lubin School of Business at Pace University in Lower Manhattan, and is the Associate Director of the William C. Freund Center for the Study of Securities Market.