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United States Should Pursue "Tough Love" Approach to North Korea in Wake of North-South Summit

June 22, 2000

Washington, DC—The recent North-South summit and North Korean statements praising Chinese economic reforms may signal a strategic reorientation on the part of North Korea. If North Korea is serious about reform and adhering to international norms, it should be supported in this process. If the North adopts only the techniques but not the underlying values of reform, however, the United States, South Korea, and Japan could be confronted with a strengthened adversary on the Korean peninsula. The intent of the Kim Jong-il regime will be the deciding factor.

In this context, the United States should adopt a new "tough love" approach toward North Korea. That country is the largest recipient of US foreign assistance in Asia yet it continues to threaten US interests. According to Avoiding the Apocalypse: The Future of the Two Koreas, by Senior Fellow Marcus Noland, the United States should encourage a North Korean transition from welfare to workfare. The United States should encourage North Korea to engage in legitimate commerce and discourage its reliance on arms sales and illicit activities such as drug trafficking and counterfeiting. The partial lifting of sanctions is a good first step. Beyond this, the United States should:

• reduce the provision of humanitarian assistance through the North Korean government,
• instead lead a multinational effort to provide humanitarian assistance and refugee resettlement to those fleeing the Stalinist dynasty, and
• show a willingness to renegotiate the Agreed Framework by scrapping the light-water reactors and offering larger and more useful economic assistance packages in return for more intrusive monitoring of North Korea's nuclear and missile programs.

The book examines the future of the Korean peninsula in terms of three scenarios: successful reform in the North, the collapse of the North and its absorption into the South, and an intermediate scenario of "muddling through" in which the North makes ad hoc adjustments supported by foreign powers.

Reform could tremendously benefit the North Korean economy as demonstrated in chapter 7 of the book (see figure 1). Yet reform would be difficult for both economic and political reasons. North Korea is a more industrialized economy than were China or Vietnam when they undertook reform (see table 1) and an opening of its economy would lead to increased economic interaction with South Korea and Japan, two countries with which North Korea has a troubled history (see table 2). The divided nature of the peninsula and the dynastic aspects of the Kim Jong-il regime also create political obstacles to reform.

In the absence of reform, however, economic failure could lead to the collapse of the North and its absorption into South Korea, costing the South hundreds of billions of dollars as shown in chapter 8 (see figure 2). This would slow economic growth in South Korea and the distribution of income would likely shift toward capital from labor and, among labor classes, toward more highly skilled workers. This would heighten income and wealth inequality in the South.

South Korea, Japan, and China would prefer the maintenance of a "domesticated" North Korea to its collapse and can be expected to support a policy of "muddling through" as argued in chapter 9. The United States is unique in this regard in that its preferred policy would be for unification on Seoul's terms, thus resolving the humanitarian and strategic challenges to US policy posed by the continued existence of the Kim Jong-il regime.

Policy Recommendations

Avoiding the Apocalypse makes a number of recommendations for South Korea, the United States and others.

South Korea

In South Korea, heavy government intervention in the private sector has largely outlived its usefulness. According to the book, the challenge now is to develop political and economic policies for "constructive disengagement." This task, daunting in its own right, is made enormously more difficult by the existence of North Korea.

Although South Korea has made considerable progress since the 1997-98 crisis, the recent travails of Hyundai demonstrate that the country is by no means out of the woods. Fortunately, the reforms needed to strengthen the South Korean economy are precisely those that would be advisable in anticipation of a collapse-and-absorption scenario. As detailed in chapter 10, a policy of "constructive disengagement" by the South Korean government would:

• subject the large conglomerates (chaebol) to increased capital market discipline through improved accounting standards, installation of outside directors, reduction in state involvement in banking, increased reliance on direct finance, and promotion of the development of independent institutional investors capable of monitoring management decisions;
• promote competition in product markets by strengthening the Korea Fair Trade Commission and aggressively liberalizing international trade to generate "imported competition";
• lessen labor market rigidity by reducing labor market regulation and strengthening the social safety net;
• return to a policy of fiscal prudence, accumulating surpluses to be used in case of the collapse and absorption of North Korea;
• promote the constructive transformation of the North through engagement measures with the greatest possibility of encouraging systemic change, such as direct investment outside of special economic zones and through encouragement of North Korea's membership in the Asian Development Bank, World Bank, and International Monetary Fund.

In the event of a collapse, South Korea will be confronted with some difficult policy choices. The book argues that at the time of unification, the South Koreans should:

• adopt a dual rate monetary conversion. Aim for slight undervaluation of the North Korean won to maintain competitiveness, thereby making the North attractive for investment. Convert personal savings at an overvalued rate, thus effecting a wealth transfer;
• deed land to the tiller and the housing stock to its occupants, contingent on its maintained use for a specified period of time;
• maintain a temporary, emergency, nonmarket social safety net in the North.

Having given the land to the tiller, Korea would also have to deal with issues of property rights claims by past owners or their descendants, and the assignment of property rights to commercial or industrial assets. Lessons from the experience of East Germany and other former centrally planned economies are instructive in this regard:

• Avoid restitution for seized assets.
• Privatize quickly and avoid the cash-on-the-barrelhead model. Abolish interenterprise debts.
• Emphasize investment, not consumption, transfers.
• Accept assistance from foreigners, including the Japanese.

As discussed in chapter 10, the extent of political rights accorded to former residents in the North will strongly affect all these policies. It will be imperative that North Koreans be incorporated into the political life of the unified country, through a de-Nazification-like process for the elite and proactive policies of inclusion for the masses.

The United States

The United States should support the recovery of the South Korean economy. It can best do this by:

• keeping its market open and
• cooperating with South Korea in venues such as the Group of 20 to forestall future financial crises.

With regard to North Korea, the United States pursues dual objectives of addressing the humanitarian crisis and reducing the strategic threat that North Korean activities pose to US interests both in Northeast Asia and the world. Having lifted sanctions, the United States should:

• reduce its provision of humanitarian assistance through the North Korean government;
• promote a multilateral effort to deliver humanitarian assistance to North Koreans outside North Korea, including taking in North Korean refugees for resettlement;
• indicate a willingness to reopen the Agreed Framework to provide more useful forms of economic assistance instead of the light-water reactors.

Japan

Like the United States, Japan's first priority should be to promote continued recovery in South Korea. This means stimulating its own domestic demand and eschewing a weak yen or export-led recovery.

The settlement of post-colonial claims between Japan and North Korea, potentially worth $20 billion, is the single largest financial claim that the North has on the rest of the world. Although the ultimate settlement is likely to be far smaller, these funds, if properly deployed, could go a long way in financing the rehabilitation of the North Korean economy. It is imperative that resolution of this issue be coordinated closely with Washington and Seoul.

Japan should finance humanitarian relief for North Koreans outside North Korea and accept refugees for resettlement, despite the political discomfort this may entail.