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Justin Yifu Lin on China's reform path and "shock therapy"
Ex-World Bank Chief Economist & SVP on why "Collapse of China" narrative persists
This newsletter features a translation of the Chinese article《 “中国崩溃论”为何挥之不去？》Why the “Collapse of China” narrative persists. Sourced from a recently-published book in China and attributed to Prof. 林毅夫 Justin Yifu Lin, currently Dean of Institute of New Structural Economics at Peking University and former Chief Economist and Senior Vice President of the World Bank (2008-2012).
This is not a long article, and the original Chinese is posted at the end. Again, thanks go to Dot Dot Stand, a China tech news site, for graciously doing the key and first round of copyediting the translation here.
The translation hasn’t been approved by Prof. Lin.
Why the “Collapse of China” narrative persists
We embarked on a different development path in 1978 and have achieved impressive results, but why has the narrative of the “Collapse of China” persisted over the past 40 years? How come we keep hearing the narrative about the imminent collapse of China’s economy? The main reason is that our way of thinking on transformation is different from the prevailing one in the world at that time.
We initiated reforms in 1978. In the 1980s, reforms were underway in almost all developing countries. For the reforms in developing countries, the mainstream international view at the time (what we now call the “neoliberal” view) held that developing countries fared poorly because the government had made excessive interventions in the market and caused its distortion, resulting in a misallocation of resources. Rents emerged as a result of government intervention and market distortion. In terms of economics, there were issues including rent-seeking, corruption of all types, and unfair income distribution.
For the transition from a planned economy to a market economy, it was necessary to replace government intervention in the market with the establishment of a sound market economy system. In other words, to develop the economy, the governments of these developing countries should withdraw from the market and establish a market economy system as sound as that of developed countries.
How to establish a sound market economy system? What was proposed at that time were privatization, marketization, balancing the fiscal budget, and liberalization. Why were the views at the time? Because in a market economy system, the prices should be determined by the market. This is what marketization implied. The market determining the price of products is the basis of a market economy.
The view at the time was that: a state-owned enterprise (SOE) will be subsidized by the state when it operates at a loss. In this situation, the company will not be responsive to price signals. For one thing, the SOEs do not care even if the price of the production factors is high, because they will be subsidized by the government. For another, even if the price of their products is high, SOEs will not necessarily increase production, because they think that any profit earned will be given to the state and their directors and managers do not benefit from higher profits. Only the owners of private companies, who pursue higher profits, would make targeted decisions in response to price signals. Therefore, the second idea at that time was that enterprises must be privatized.
At the same time, prices at the macro level must be stable. If hyperinflation occurs, the price will lose its effectiveness in allocating resources. To stabilize prices, the prerequisite is that government must have a balanced fiscal budget. That’s because if there is a large budget deficit, monetary approaches will be adopted - to print more money - to compensate the government’s fiscal deficit. Inflation will occur in the wake of the additional currency supply. If inflation is running high, the price will lose its effectiveness in guiding resource allocation.
These ideas about reform at that time all seem to be linked: In order to establish an institutional mechanism for the market economy, the allocation of resources must be determined by prices. However, only with institutional arrangements for private property rights, will companies make decisions based on price signals, and will the allocation of resources be determined by the market. At the same time, governments must maintain the stability of the macroeconomy to bring into play the price signals. This is later called by many as the “Washington Consensus”.
China initiated reform in 1978, but instead of adopting the approach considered the best at the time, China took a gradual, dual-track approach to transformation. This gradual and dual-track approach was adopted because there were many large capital-intensive SOEs in the early days of reform and opening up. And these SOEs would not be able to survive without protection or subsidies, because they were capital-intensive and against China’s comparative advantages.
Therefore, the transformation approach at that time was that necessary protection and subsidies were still provided to these enterprises. For labor-intensive processing industries, whose development was suppressed in the past and stands in line with China’s comparative advantages, the government relaxed access - township and village enterprises, private enterprises, and foreign enterprises could all enter.
In addition to relaxing access, governments proactively seized the momentum and guided the development of these enterprises, by establishing industrial parks, export processing zones, special economic zones, promoting investment, and rolling out favorable policies, so that labor-intensive industries could develop.
There was an international consensus at the time that a gradual, dual-track reform like that adopted by China was the worst approach to transformation. If the transformation was carried out in this way, the Chinese economy would perform worse than it was in the planned economy period. Their view was that: in the planned economy period, what the government did was just direct resources to SOEs.
If a gradual, dual-track approach was adopted for transformation as what China did, government protection and intervention in the market would cause market distortion on one hand, and, on the other hand, if market access was partially liberalized, extensive corruption could occur. There is a price difference between the government-controlled price and the market price, which will lead to rent-seeking.
All the students here today may not have heard the Chinese word “Dao Ye (倒爷)”, meaning a profiteer, but the teachers here know that there were many so-called “profiteers” in the 1980s. If the government-controlled prices were low and market prices were high, “profiteers” sought approvals to buy stuff from the government and resold them on the market at a profit. Corruption occurred in this way, and bribery was common. Therefore, it was believed that the Chinese economy at this time was worse than the planned economy.
This indeed emerged in China. However, what happens to the countries which adopted the “shock therapy,” thought to be the best way for transformation and prescribed by the “Washington Consensus”? The result was that their economy either collapsed or stagnated, and crises cropped up one after another. Moreover, the problems of corruption and income distribution were more serious in those countries than in our country.
How come the neoliberal theory seems to have a coherent and clear logic, but the result of its implementation is just the opposite of what was expected? How come the countries that adopted the “shock therapy” ended up with a collapsed or stagnated economy, continuous crises, and more rampant corruption problems? I think the principal reason is that this theory does not take into account the purpose of economic intervention and distortion. The purpose of intervention and distortion was to provide protection and subsidies for capital-intensive and large-scale SOEs. Those SOEs were against the comparative advantages. After privatization, they would not survive without protection or subsidies. What would happen if they did not survive? For one thing, SOEs were large in size with a large number of employees. Many of them would be laid off if SOEs went bankrupt, which may cause social and political instability. For another, the products of some SOEs are related to national defense and security. National defense and security would be jeopardized without these SOEs and their products.
After 40 years of reform and opening-up, China has now become an upper-middle-income country. As capital accumulates, many old industries have evolved to conform to comparative advantages and they should be able to make a profit and face market competition in an open and competitive market as long as they are properly managed. In this situation, the protection and subsidies lose their meaning. From the perspective of enterprises, the more protection and subsidies, the better for them. From the perspective of the nation, granting protection and subsidies will result in rent-seeking and corruption. It comes with social and political costs.
Therefore, in 2013, the Third Plenary Session of the 18th Central Committee of the Communist Party of China put forward comprehensively deepening reforms. One of the main goals of comprehensively deepening reform is to allow the market to play a decisive role in resource allocation. How can the market play a decisive role in resource allocation? The answer is to eliminate the protection and subsidies. Conditions are ripe for elimination.
Many industries that could not survive without protection or subsidies are now highly competitive. For example, Sany Heavy Industry in the equipment manufacturing sector is highly competitive internationally. Xuzhou Construction Machinery Group, a state-owned enterprise, can also compete internationally. The Chinese automobile industry has an annual output of 30 million vehicles, the largest in the world, and Chinese vehicles can compete with imported automobiles. Some of them can compete internationally because they have comparative advantages now.
Therefore, the protection subsidies granted in the 1980s and 1990s to enterprises for their survival can now be abolished. After that, the market can play a decisive role in resource allocation. Of course, the government has to play its due role.
【Note: 找市长 (through the mayor) or 找市场 (through the market), which have similar spelling and pronunciation, is a common metaphor in the history of China’s reform illustrating economic activities leaning on state power or the market economy.】
This gradual reform actually creates the necessary conditions for subsequent reforms. At the same time, if protection and subsidies of all types are abolished, corruption can be rooted out, because corruption stems from rent-seeking behavior caused by government intervention. If the market determines the prices and allocates resources, most people would rely on the market instead of the mayors. Government intervention is still ongoing, so enterprises turn to the mayors instead of the market and corruption occurs consequently. If resources are all allocated by the market, it would be useless to turn to the mayors. Enterprises would have to turn to the market. There would naturally be no corruption if the mayors were not involved. Therefore, the abolition of protection and subsidies will help root out corruption.
Due to a mistaken way of thinking, many countries adopted the wrong approach to transformation and ended in failure. We actually had the best approach to transformation, but economists at the time generally held that this was the worst way. When our economic development slows down a bit, they think that China’s economy is about to collapse, because they think the economy is unlikely to develop sustainably under the worst approach. From 1978 onwards, our economy has grown by 9.5% per year on average. It does not mean the annual growth rate has remained at 9.5%. The growth may have reached 11% or 12% at its height and fallen to 8% at its low point. As long as there is a slowdown in growth, they tend to talk about a coming collapse of China’s economy. I think this is largely caused by misunderstanding.
(Excerpt from Lectures at Peking University Hall for Well-known Masters on Theory (volume 1), People’s Publishing House, October 2021. Translated from the Chinese version available on the app of Beijing Daily 北京日报.)