“Three billion new capitalists,” a new book by Clyde Prestowitz, head of the Economic Strategy Institute, highlights the potential rewards and dangers to the U.S. economy inherent in the full emergence of India and China’s 2.5 billion people (and the former Soviet bloc’s 500 million) onto the world’s economic stage. Old patterns are dissolving, old rules are no longer valid, but the new patterns and new rules to deal with them remain shrouded in mist.

Most interestingly, Prestowitz, speaking at a UBS Financial Forum meeting Monday, pointed out that some well established economic “laws” such as the Doctrine of Comparative Advantage appear to be partially untrue in a world where the number of skilled or potentially skilled workers has more than doubled and is rising rapidly. The Doctrine, propounded by David Ricardo in 1817, assumes that the low wage workforce to which production is outsourced cannot (directly or, through the Internet, virtually) move to the high wage country, and that it does not through its low wage work acquire additional skills that allow it to move into higher value added areas. If those assumptions are untrue, then, as I have written previously, the Doctrine is invalid.

For manufacturing or primary sector activities in 1817, the Ricardian assumptions were generally true, although it is notable that even around that time Francis Cabot Lowell, who founded the U.S. textile industry, was forced to smuggle plans for textile machinery out of Britain illegally; neither the plans nor the machinery itself were available on the open market. However, in high value added modern services, the delivery of which is facilitated by the Internet, the Ricardian assumptions are very shaky indeed.

If software writing is outsourced to India, there is nothing to prevent the educated and skilled Indian workforce from using the experience it gains to move up the value chain to become fully fledged software engineers and hollow out the United States’ software capability. Interestingly, even though manufacturing can now be outsourced as easily as services, the manufacturing-dominated economy of China appears to cannibalize the United States’ core capabilities less than the service-oriented modern sectors of India’s economy. Competition from the Chinese textile industry, for example, falls squarely within David Ricardo’s original model, and hence, contrary to the beliefs of most of Congress, Ricardo’s arguments against protectionism remain valid in this sector.

Prestowitz believes that the economic rise of India and China represents a major problem for the United States, and that the U.S. government needs an economic strategy in order to combat its effects, and prevent the disappearance of much of the United States’ remaining manufacturing and high level service capability. He notes with approval that when IBM began to consider selling its PC business to China’s Lenovo, IBM Chairman Louis Gerstner went to China and discussed industrial strategy with Chinese President Jiang Zemin, whereas no equivalent discussion was held with top officials of the U.S. administration.

Prestowitz’s belief that the United States needs a government-led strategy to deal with the major changes in the world economy has one huge flaw: history has shown that governments are not capable of getting such a strategy right. The Soviet Union lived entirely by 5 year plans, and collapsed. Japan was much lauded for its industrial strategy in the 1980s – and derided for it by the late 1990s. France operates through a high degree of government control of the economy, with its strategy devised by the finest brains of the Ecole Nationale d’Administration – and is not currently an economic example that one would wish to emulate. Given the particularly random nature of the U.S. political process, and the intensity of lobbying through the campaign finance system, it seems most unlikely that any U.S. administration could formulate a long term economic strategy that was anything more than a gigantic and wasteful pork-barrel.

Nevertheless, if Prestowitz’s solution is wrong, his diagnosis appears largely on the mark. The problem may not be quite as severe as he believes, in that the industries and services that can be outsourced to India and China remain a modest proportion of the overall economy (for example, you can service a home mortgage from India, but you still need Wall Street to raise the money, a local realtor to buy the house and Home Depot to remodel it.) However the sheer scale of the new entry to the world economy, even without the anti-Ricardo effect in services, makes considerable disruption inevitable.

Economic laws work well, provided the conditions for them are fulfilled, but they are not instantaneous, and the Great Depression proved conclusively that a major disruption of the system may cause huge temporary unemployment that lasts for a decade or more. Thus an approach to the problem of India and China’s emergence that minimizes disruption, and delays its effects, is itself helpful. If the United States’ principal competitive advantage is its speed of innovation, it needs to make sure that jobs are being added through innovation more rapidly than they are being removed through outsourcing.

We need to make the positive effects of the new entrants into the global workforce as great as possible, while minimizing and delaying the negative impacts. Simple protectionism is both immoral (because it would leave the Chinese and Indian people mired in poverty) and unlikely to be effective. However there are a number of steps that can be taken to reduce the comparative cost disadvantages of the United States and Europe, and thereby both slow the transition to Indian and Chinese manufacturing, and minimize the disruption it causes

First, and most important, the United States needs to raise interest rates and allow world stock markets to enter the sharp fall that has been artificially delayed so long. Probably the most important competitive advantage of a developed economy over an emerging economy is its lower cost of capital. Capital assets, accounts receivable, inventory and infrastructure are much cheaper and easier to assemble in a developed economy, because interest rates are lower, stock prices are higher and investment banking mechanisms more fully developed.

Over the last decade, however, money supply in the United States has increased much more rapidly than money Gross Domestic Product. This first caused a stock market boom that reduced the worldwide cost of equity capital to negligible levels. When the bubble began to deflate, a prolonged period of short term interest rates well below the rate of inflation brought a huge surge of liquidity in the debt markets. Risk premiums in both debt and equity markets consequently collapsed – with so much money around, investors in both debt and equity markets have been for the last decade in desperate search of higher returns.

In the late 1990s, the bubble in new stock issues made capital raising in the tech sector extremely cheap both in the United States and worldwide, while huge amounts of cheap loans flowed to countries such as Argentina that subsequently defaulted. Since 2001, cheap money has produced a massive bubble in the U.S. housing market, driving up house prices on the two coasts to unprecedented levels, together with a further collapse in risk premiums for emerging market bonds and a flood of private equity investment into China and to a lesser extent India. Thus bonds from Bulgaria and Brazil, both of which yielded more than 10 percent over Treasuries in 2001, now yield respectively 1 percent and 3 percent over Treasuries.

Not only has the last decade’s flood of liquidity produced a massive waste of U.S. resources, with successive waves of investment in idiotic dot-coms and unnecessary and overpriced housing, but it has also greatly weakened the U.S. cost advantage in two areas. Cheap housing, which before 2000 allowed U.S. living standards to be much higher than those in Europe even when money wages were similar, has disappeared on the coasts, producing a substantial new U.S. competitive disadvantage against its emerging market competitors. Meanwhile cheap and readily available money has allowed U.S. competitors in emerging markets to develop their facilities with remarkable speed, since they no longer suffer the disadvantages of expensive and scarce capital that had for decades prevented them from out-competing U.S. businesses.

Higher interest rates and a lower stock market will over time produce cheaper U.S. housing. They will also reduce U.S. consumption, increase the U.S. savings rate and reduce U.S. imports, all elements in rebalancing the international economy. Finally, by restricting capital availability to non-prime companies, they will slow the outsourcing of U.S. businesses to India and China while at the same time increasing returns for the high-saving Indian and Chinese people. They will reduce the rate of new startups in the United States, but as the late 90s demonstrated, it is the wasteful and frivolous startups, not the truly innovative ones, that benefit from cheap venture capital and a stock market bubble.

A second element in slowing the loss of U.S. and EU jobs and consequent impoverishment of their people is to reduce immigration. Whereas outsourcing to India and China threatens jobs only in certain sectors, high immigration of low-skilled people produces vicious competition for domestic jobs throughout the low-skill parts of the economy, thus having an even more damaging effect on the local inhabitants’ welfare than trade alone. Without secure adequately paid low skill jobs, the local workforce cannot form stable families, and hence turns to crime and other social pathologies. Particularly in an economic downturn, it is essential in both the United States and the EU to bring immigration back down to the much lower levels of the 1970s.

The chief beneficiaries of outsourcing and high immigration are the same people, the wealthy and the corporate sector. This has resulted in a large increase in inequality in the United States in the last decade, making U.S. society more akin to Latin America than Western Europe, and producing many of Latin America’s political and social pathologies. This would be less of a problem if the wealth flowed through to shareholders, so that the U.S. people could benefit from it through their pension plans and mutual fund holdings, but in practice only part of the new wealth has flowed to shareholders, with much of it being diverted through excessive bonuses and stock option schemes to corporate management.

Accounting rules need to be tightened, so that shareholders are more aware when management is rewarding itself excessively; more important, auditors must be appointed directly by the shareholders, and not by management or its cronies, so they are fully oriented towards the interests of the shareholders for whom they nominally work.

In this context, the replacement of the able William Donaldson at the head of the Securities and Exchange Commission by Rep. Christopher Cox (R.-CA) is an ominous development. Cox has been altogether too forgiving of the scams perpetrated by California tech sector management, and in particular opposes the expensing of stock options, the single post-Enron reform that would do most good. An economy that is built on corporate management using accounting flim-flam to defraud stockholders is both fundamentally sick and hopelessly uncompetitive in the long run. Only when the wealth from outsourcing flows fully to the American people through their direct and indirect holdings of U.S. stocks will its costs and benefits be properly aligned.

Finally, the immense overhead of government, in the United States and more particularly in Western Europe, is a pure deadweight on the economy that needs to be drastically slimmed down in order to improve economic competitiveness. In the United States, military adventures with no clear purpose must be eschewed, infrastructure and other pork-barrel spending must be eliminated and “reform” of social security must reduce the size of the transfer payments involved, by raising the retirement age, not increase them through additional taxes on the most productive members of society. In Europe, the demographic time-bomb of the welfare state must be addressed by reducing benefits and increasing retirement ages, the appalling waste of resources through agriculture subsidies must be eliminated, and the Brussels bureaucracy’s nightmares of over-regulation must be rolled back.

Such a program, by reducing the speed of economic change, reducing its adverse effect on the Western economies and people and increasing the competitiveness of Western economies, will ensure that the disruption inherent in the emergence of India and China is reduced to a level that the West’s economic systems can tolerate, and that the inevitable dislocations take place at a speed that its people can handle.

The alternative, allowing rapid hollowing out of Western economies staggering under the weight of their bloated governments, will produce results too unpleasant to contemplate, and probably a geo-political reaction in the West that slams the door shut on the rightful emergence into modest affluence of 40% of the world’s population.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.