Economic Reform and Military Downsizing: A Key to Solving the North Korean Nuclear Crisis?

Mike Mochizuki and
Mike Mochizuki Associate Professor of Political Science and International Affairs, Elliott School of International Affairs - The George Washington University
Michael E. O’Hanlon

September 1, 2003

U.S. policy toward North Korea is in need of a major overhaul. Six-party negotiations in Beijing in late August did not break down, but neither did they achieve any substantive progress. Meanwhile, North Korea continues to develop a nuclear arsenal right before our eyes. We propose an ambitious plan that would get to the heart of the matter—North Korea’s broken economy and other aspects of its failed society—by proposing a grand bargain to Pyongyang. North Korea would be offered a new relationship with the outside world and substantial aid if it would denuclearize, reduce military forces, and move in a direction similar to that of Vietnam and China in recent decades. If the plan failed, Washington would have a huge consolation prize—having seriously attempted diplomacy, it would then be in a much stronger position to argue to Seoul, Tokyo, and Beijing that tough measures were needed against North Korea.

Despite some impressive successes, notably the 1994 Agreed Framework capping North Korea’s nuclear activities, the Clinton policy of engagement does not offer a promising route. That approach was effective for a time but was somewhat too narrow and tactical, focusing largely on the crisis du jour. The approach appears ultimately to have encouraged in North Korea’s repressive leaders a worsening habit of trying to extort resources from the international community in exchange for cutting back its dangerous weapons programs.

President Bush is impatient with this sort of attempted blackmail. But his apparent policy preference—insisting that North Korea immediately stop its nuclear activities and severely limiting talk of possible incentives to Pyongyang until it does—may fail. To date, it clearly has been failing, as the North Korean situation has changed from a serious security problem to a major crisis on his watch. North Korean leaders tend to become more intransigent when their backs are against the wall, and they are clearly willing to see their own people starve before capitulating to coercion. Pushing North Korea to the brink may also increase the odds that it will sell plutonium to the highest bidder to rescue its crumbling economy and preserve its power.

North Korea is now well into its second decade of poor economic performance, and its leaders do not seem to know what to do. They have tried modest reforms—price liberalization, special economic zones, and limited business transactions with South Koreans—with little success. They have not yet been prepared to take the risks associated with China-style economic reforms, and their instincts still push them toward high military spending. The ——1 million troops out of a population of 22 million—is the largest in the world in per capita terms and 10 times the global average. North Korea devotes a far greater share of gross domestic product to its armed forces than any other country, and its forces arrayed near the demilitarized zone with South Korea are the densest concentration of firepower in the world by far.

We propose a plan that would address the nuclear weapons crisis that has so dominated headlines in recent months—and would also go much further to recast North Korea’s overly militarized economy (see box). Its centerpiece would be a combination of deep conventional arms cuts, economic reform, and external economic assistance aimed at reform. President Bush himself, shortly after taking office, suggested the need for conventional arms cuts in North Korea in exchange for continued aid and diplomatic relations. Though the administration did not follow up on the president’s suggestion, the idea is worth pursuing seriously. Aside from the security value of reducing North Korea’s huge military presence on the Korean peninsula, a fleshed-out plan along those lines could reduce the enormous economic burden that pushes North Korea to provoke nuclear crises to extort resources from the international community.

Our plan to prod North Korea toward demilitarization and serious economic reform and to provide the resources to give reform a real chance offers no guarantee of success. But it also has few downsides. Failure would leave us no worse off than we are today. In fact, it would probably improve our hand in convincing South Korea, Japan, and China to adopt a tougher policy toward North Korea as needed. Success would admittedly help a totalitarian regime stay in power. But the alternatives—further economic collapse attended by misery and starvation, war, or the sale of nuclear weapons if the nation finds itself on the verge of collapse—are worse. And under our plan, the regime would be radically transformed even if it clung to power.

The Rise and Fall of the North Korean Economy

When the Korean peninsula was divided after World War II and set free from Japanese colonization, North Korea had a relatively strong economy. It boasted three-fourths of the peninsula’s mining production, at least 90 percent of its electricity generation capacity, and 80 percent of its heavy industry. The South, with a better climate, was largely an agricultural region. North Korea quickly nationalized major industries and drove up production. Its economic success probably contributed to President Kim Il Sung’s confidence that he would win a war against the South, which he unleashed in 1950.

North Korea continued to outperform South Korea immediately after the war. But the seeds of its eventual economic deterioration were soon sown. It collectivized agriculture in 1953 and increasingly invested in heavy industry, much of it defense related, while turning inward and autarkic. Kim Il Sung’s juche concept of self-reliance kept North Korea isolated from the outside world and deprived it of foreign trade.

By the late 1960s, North Korea was devoting 15–20 percent of its GDP to the military, and its economic growth gradually slowed. During the early 1970s Pyongyang tried to boost output by borrowing capital on international markets and purchasing whole factories from abroad. But oil price shocks and global stagflation thwarted that strategy. Matters thereafter went from bad to worse. The nation came to depend more and more on economic relations with the Soviet bloc, importing arms and exporting minerals, textiles, steel, and other goods. It also increased its own arms exports, largely to Iran. When the Soviet Union dissolved, North Korea lost access to most of its markets and also to subsidized Soviet oil. China provided coal and oil on favorable terms to stanch the flow of North Korean economic refugees across its borders, but even so, by the end of the decade North Korean energy resources were about half what they had been in 1990.

In the past 13 years, North Korea has suffered continuous economic contraction. GDP and per capita income have been cut roughly in half. Alternating periods of drought and flooding, together with a broken political system, have exacerbated agricultural problems. Famine has killed hundreds of thousands of North Koreans despite food aid from abroad.

Attempts at Reform

For the better part of 20 years, North Korea, like China, has shown an interest in finding a “third way” between communism and capitalism. But unlike China, it has not shown a serious commitment to reform and has achieved little success.

As its economy has worsened, North Korea has grown ever more dependent on extortion, drug trafficking, counterfeiting, whatever arms exports it can still find markets for, and cash remittances from overseas North Koreans. Its foreign trade is roughly half what it was in the 1980s. About half of all imports come from China, much of the rest from Japan and South Korea. Likewise, exports go principally to Japan, South Korea, and China. North Korea also still receives aid—mostly food and energy—averaging up to $1 billion a year from China, South Korea, Japan, the United States, and the European Union.

Given its poor track record and the leadership’s continuing communist rhetoric, North Korea’s dedication to economic reform today is weak. Its leaders surely fear that liberalizing the economy could lead to political liberalization—and thus their own loss of power. Still, President Kim Jong Il, Kim Il Sung’s son and successor, and other North Korean leaders seem to be searching for alternatives. Kim Jong Il has visited China at least three times since May 2000, traveled to economic centers in Beijing, Shanghai, and Shenzhen, and received briefings from Chinese economists. Korean Workers Party functionaries have also met with their Chinese counterparts to explore reform at the working level. The challenge for the United States and its chief regional allies in this matter—South Korea, Japan, and China—is to give North Koreans a push to take reform more seriously.

North Korean leaders have made three types of reforms to date. They have created special economic zones, in which they have encouraged foreign investment. They have allowed South Korean tourists to visit the North, demanding expensive surcharges for the privilege. They have also recently liberalized prices, increased wages, and begun to tolerate limited private agriculture as well as an expansion of farmers’ markets where goods can be bought and sold outside the rigidities of the command economy.

North Korea established its primary investment-oriented economic zone in the Rajin-Sonbong area, also known as the Tumen River delta, in the early 1990s. More than 700 square kilometers in area and deliberately removed from much of the rest of the country, it benefits from relatively good natural port potential. The terms granted to foreign investors here are more generous even than those granted by China and Vietnam in their similar zones, at least on paper. Foreign firms can own all the capital invested in a given project, repatriate profits, access the region without visas, enjoy guarantees against nationalization of their assets, and possess 50-year leases on land.

So far, however, the region has yet to attract much capital. By the end of the 1990s, foreign investments totaled no more than $34 million, and progress appears not to have accelerated. Problems include poor infrastructure, the great distances from Pyongyang and other cities, and high wage rates. Unresolved geopolitical tensions also hinder investors. Whatever the region’s ultimate prospects, recent times have seen a decline in South Korean ventures in the North. Would-be foreign investors voice continued frustration with political and economic conditions in the region and the country as a whole.

In other moves to increase foreign private investment—and win desperately needed support from international financial institutions—North Korean leaders have lobbied the United States to lift trade sanctions and to remove North Korea’s name from the U.S. list of state sponsors of terrorism. They have also attempted rapprochement with Japan. But these efforts too have been generally unsuccessful to date.

Other reform efforts have also faltered. Although South Koreans pay up to several hundred dollars a person to visit certain important sites in North Korea, much of the cash appears to have wound up in the hands of the regime for its own uses, not for nationwide development efforts. And although in 2002 North Korea finally liberalized prices and raised wages in much of the country, the nation’s distorted industrial production base, poor trade balance, and limited natural resources have hamstrung the reform move. Inflation has become severe, and some industries are reportedly unable to pay workers the promised higher wages.

Prospects for Recovery and Reform

Against this backdrop, could a serious program of economic reform buttressed by outside resources succeed?

One big plus is the nation’s workforce. As its South Korean counterpart has demonstrated, Korean culture, with its emphases on hard work and group effort, is capable of remarkable things. And North Korea’s population is reasonably well educated, despite heavy doses of propaganda in school and decades of isolation from the outside world. A transition period would be necessary, but on balance North Korea’s human raw materials are impressive.

China’s experience also provides an important model for North Korea, as its leaders seem to recognize. The PRC’s ability to take an economy that Mao had largely destroyed and, without losing political power, turn it into one of the fastest- growing countries in the world must hold enormous appeal for North Korea’s leaders. To be sure, reform could be harder in North Korea. China’s reforms began only after Mao had departed the scene, whereas Kim still rules. China was able to accomplish many reforms by making agriculture more efficient, taking workers off the land and putting them into industrial activity. Because North Korea already has a large share of its workers in industry and a relatively small share in agriculture, its leaders would have to take workers from unproductive industry to devote to more productive nonfarm enterprises. But North Korea has available another huge source of productive manpower—its military. Downsizing its armed forces would be a key to reform, for it would free the nation’s youngest, strongest, best workers for important tasks in the years ahead.

Many economists are positive about what reform could accomplish. In Avoiding the Apocalypse, Marcus Noland shows that North Korea’s real GDP might be expected to grow anywhere from 60 percent to almost 100 percent under various assumptions about reform. As he puts it, “There are solutions to North Korea’s economic problems?.The real issue is whether reform would be compatible with the continued existence of the Kim Jong Il regime?.” On this latter point, Noland is agnostic, as are we. But that is no argument against proposing reform as part of a grand bargain to Pyongyang and trying to negotiate an acceptable arrangement.

Many scholars and officials in Northeast Asia have concluded that North Korea has little choice but to try such reforms. Our plan would encourage leaders in Pyongyang to get the message and act on it.

The Role of External Aid in Reform

Given the North Korean regime’s apparent interest in economic reform, but uncertainty how to make it work while maintaining political control, how can outside powers play a constructive role?

Clearly no guarantees for success exist. But the downsides to trying seem few. The cost to the United States, Japan, and South Korea would be small, especially when weighed against the security implications of the likely alternatives—either a collapsing North Korea possibly willing to sell fissile materials abroad or war on the peninsula. Successful reform would gradually change North Korean society, making life better for citizens while forcing the nation’s leaders to modify at least some of their ways. Failure would leave the United States no worse off than it would have been otherwise, especially since the North Korean nuclear program would have been capped in the interim in any event. (This would be a precondition to any negotiation, along with a U.S. pledge not to use force against North Korea while talks continued and a resumption of U.S. fuel oil shipments to North Korea.) Outside aid would be provided over time, rather than in a lump sum. There would be a strong presumption that the aid would continue from year to year, even in the face of setbacks in reform. But Washington and its allies would retain an unspoken leverage over Pyongyang to continue its compliance with the plan and gradually expand economic reforms. The aid efforts would serve as a form of pilot project, while also giving leaders in Pyongyang confidence that they could manage reform as it gradually spread countrywide. To the extent that North Korea allowed nationwide aid efforts and continued to support the economic reforms needed to make aid work, assistance would expand. In the first couple of years, aid would focus on improving infrastructure, mainly in the special economic zones. Implementing such projects should be relatively straightforward. Broadening the aid effort nationwide would require North Korea to accept a greater international presence on its territory and to accept more changes to its educational, agricultural, public works, and health care sectors. China could mitigate North Korean fears by providing most of the on-the-ground development experts, with funding itself coming in large measure from Japan, South Korea, and the United States. Initial success in the special economic zones might also increase North Korea’s confidence in the package deal.

Above and beyond humanitarian relief and energy assistance, North Korea would probably need an average of roughly $2 billion a year for a decade to embark on the path of economic recovery. In per capita terms—roughly $50–$75 a year—the total is commensurate with that given such development success stories as Taiwan and South Korea.

There is good reason to think that Japan might provide much of this assistance as a form of reparations for its colonial occupation of Korea until 1945. Japan provided $500 million to South Korea during the 1960s; adjusting that number to account for inflation and economic growth would lead to aid in the range of $5–$10 billion.

Other outside assistance would also be critical. As an expression of its good faith and its commitment to improving relations, the United States would have to go beyond its current humanitarian aid, roughly $200 million a year. It would also lift all trade sanctions and provide funds to develop North Korea’s infrastructure. Its annual development aid to North Korea might reach roughly $300 million a year. The total aid—about $500 million annually—would be well below what it gives Israel and Egypt and roughly comparable to the amount it provides to the next tier of U.S. aid recipients—Jordan, Afghanistan, Pakistan, and Colombia. The United States, one of the least generous aid providers among the major industrial economies as a share of its national wealth, can certainly afford this expansion in aid to North Korea.

South Korea and China would clearly be critical players too. Both are already providing more aid to North Korea than the United States is. South Korea, which has largely recovered from the 1997 Asian financial crisis, should be able to provide much more assistance under this type of radical overhaul in North-South relations. But its private sector would be the real growth engine, investing in North Korea on a major scale over time. Aid would largely lay the economic groundwork for this private investment. China would help North Korean leaders learn how to create a mixed economy that retained command features in some areas but enterprise zones in others, one that gradually carried out further price liberalization nationwide.

Prospects for Success

The prospects for this aid effort are unclear. But it has a good chance of succeeding if North Korea wants to make it work. Expectations, of course, must be reasonable—North Korea need not become another South Korea, or even another China, anytime soon. Vietnam might be a better near-term model. As first priorities, North Korea needs to fix its economy enough to take care of the basic survival needs of its people, get out of its extortionate habit of trying to use dangerous weapons programs to gain hard currency, and stop counterfeiting and drug running. More broadly, it must accept a vision for constructive engagement with the international community. By convincing Pyongyang to do so, the United States and its partners can use aid to achieve much better national security.

The benefits of the aid effort would go beyond its immediate prospects for economic success. By uniting the major powers of Northeast Asia in pursuit of a common vision for the Korean peninsula, it would harmonize the interactions of Washington, Seoul, Tokyo, and Beijing as they face the simmering nuclear crisis. These four capitals have had a difficult time uniting around any Korea policy, and their confusion and open dissension not only have hurt the prospects for collaboration but also complicate coordinating policy in case things go badly wrong and more dire measures need to be considered.

A combination of conventional force reductions and major economic reform initiatives strikes many observers as too much to add to the North Korea agenda. But more limited engagement has failed. Focusing on North Korea’s nuclear program and missile programs holds little appeal for President Bush, who feels he is being blackmailed by Pyongyang’s words and deeds in these areas. And without a broader reform effort, North Korea will remain a broken economy whose leaders will almost surely continue to resort to extortion—or worse—given their stark lack of alternatives for gaining hard currency.

President Bush’s initial instincts that North Korea needed to reduce its threatening conventional military forces if it wished more aid and diplomatic relations with the United States were on the mark. It is time now to translate that view into a comprehensive policy proposal.