Xu Gao on Establishing a Govt-Market Relationship with Chinese Characteristics
He says "the lack of effective demand in China can, in my view, be attributed to the government failing to return income to the public while also not actively spending it itself."
Below is a September 22, 2024, speech by Xu Gao, Chief Economist of Bank of China International (China) Co., Ltd, at an event marking the 30th Anniversary Celebration of the National School of Development (NSD), Peking University.
The translation is based on the transcript published on November 14 in the NSD's WeChat blog. All highlights below are mine. - Zichen Wang
徐高：构建中国特色的政府与市场关系
Xu Gao: Establishing a Government-Market Relationship with Chinese Characteristics
The current issues and challenges facing China's economy stem from an inability to properly manage the government and market relationship. How should this relationship be handled? Where should the boundaries between the market and the government lie? Today, I would like to share a framework for thinking about this.
Introduction: The Debate Between Friedrich Hayek and John Maynard Keynes
Friedrich Hayek and John Maynard Keynes have already explored the government and market relationship. The former opposed government intervention in markets, arguing that artificially creating demand would inevitably misallocate resources even in an economic crisis, potentially sowing the seeds for new disturbances and crises. As a result, Hayek advocated for non-intervention, even during a crisis. He famously stated: "We may perhaps prevent a crisis by checking expansion in time, but that we can do nothing to get out of it before its natural end, once it has come."
(Friedrich Hayek, Lecture 3, "The Working of the Price Mechanism in the Course of the Credit Cycle," in Prices and Production and Other Works, 2nd ed., 1935)
This perspective underscores Hayek's unconditional faith in the market. He doesn’t think it is feasible to construct a relationship between the market and the government.
Keynes held a fundamentally different view. He famously remarked:
"In the long run we are all dead. Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again."
(John Maynard Keynes, The Tract on Monetary Reform, 1923)
In other words, Keynes advocated for focusing on the short term, rather than waiting for the market to spontaneously recover, as such delays might come too late for all of us.
Where do the differences between Hayek and Keynes lie? Primarily in their understanding of the market's capacity for self-operation. Both agreed that the market cannot be entirely replaced by government and should hold a fundamental role. However, their divergence lies in Hayek maintaining that the market is inherently efficient. Even during an economic crisis, he argued that one should trust the market to self-correct over time. During this time, the government must absolutely not intervene, as doing so would obstruct the market's natural adjustment process and lay the groundwork for future crises.
Keynes, on the other hand, believed that market efficiency is relatively low and that one cannot wait for the market’s self-adjustment. When faced with an economic crisis, the government should actively adopt demand management policies to mitigate or even eliminate the crisis.
The divergence between Hayek and Keynes is similar to that between John Locke and Thomas Hobbes.
Hobbes believed that in the absence of government regulation, the natural state of humanity would devolve into constant conflict, necessitating a sovereign authority to maintain order. On the other hand, Locke believed that people can live harmoniously in an idyllic and peaceful state, requiring only a minimal government.
In my view, the division of boundaries between the government and the market depends critically on the state of the market. If the market is functioning well, government intervention may not be necessary; however, if the market itself faces significant issues, then government involvement becomes essential.
From the Market's Perspective: What Should the Government Do?
First, the government should intervene when the market fails or crises occur.
For example, in March 2023, the collapse of Silicon Valley Bank in the U.S. led to a significant contraction in credit issuance by banks and caused turmoil in financial markets. In response, the Federal Reserve substantially expanded its balance sheet to stabilize the market and help it navigate the crisis. This intervention received widespread praise as a prudent response. When problems arise in the market, government intervention is necessary—a consensus that has been broadly accepted.
In recent years, debates over moral hazard have frequently surrounded China's market intervention policies. Should moral hazard be a priority consideration before government action? I believe this depends on the context. Imagine a child falling into a river, and the adult refrains from intervening merely to teach the child a lesson. Such inaction would be absurd—no matter what, saving the child’s life must take precedence; considerations of how to prevent similar issues in the future can come later.
The real estate market presents a similar situation. When the market has "fallen into the water," debates fixated on moral hazard only delay rescue efforts. I think the priority should be to save the market—to help it "survive" first. This is far more important than being stuck in debates over moral hazard.
Second, the market lacks the ability to address income inequality, making it necessary for the government to implement "common prosperity" to ensure social harmony and stability.
The market economy can achieve Pareto optimality, a concept related to efficiency. However, Pareto optimality does not address income distribution. A situation with extreme income inequality can still be Pareto optimal. From this perspective, the market is incapable of correcting income inequality.
Since the onset of globalization in the 1990s, the shares of wages and corporate profits as a proportion of Americans' total income have begun to diverge. The proportion of workers' salaries decreased, while the share of corporate profits increased significantly. The U.S., a principal beneficiary of globalization, accumulated a current account deficit totaling $12.7 trillion between 2001 and 2023. This substantial deficit stemmed from the ability to generate value without direct costs in return for goods and services from global trade partners.
However, the U.S. failed to equitably distribute the dividends of globalization domestically. As a result, most of the benefits went to the wealthy, while ordinary workers suffered due to globalization. This widened the income gap, intensified class conflicts, and deepened social divisions. Therefore, the core issue in the U.S. lies within its domestic structures. As a capitalist state, the U.S. lacks mechanisms to redistribute wealth effectively across different social strata.
This scenario is a direct consequence of relying solely on the market. Looking to the future, should humanity enter an AI-driven era of fully automated production, robust government intervention in income distribution will be even more essential to ensure that the gains in productivity brought about by AI are shared equitably among all members of society.
Third, the government needs and has sufficient capacity to promote industrial development through targeted policies.
This approach is firmly supported by economic theory. In modern international trade, a significant share of commerce occurs between developed nations with comparable factor endowments. Moreover, there is a large volume of intra-industry trade, where a country simultaneously exports and imports products within the same sector.
Why does this occur? The New Trade Theory (NTT) provides a reasonable explanation. In modern industrial chains, each industry is segmented into numerous niche markets. Within these niches, economies of scale are crucial to production efficiency. When a first-mover achieves scale expansion, it secures a robust competitive edge over later entrants. Consequently, various countries, often due to random or incidental factors, develop scale advantages in specific niches, resulting in substantial intra-industry trade among developed economies.
From this perspective, governments have considerable potential to support domestic industries in attaining first-mover scale advantages. Modern NTT thus provides a theoretical basis for government intervention in industrial development, which is why it is called "strategic trade theory."
China's new energy vehicle (NEV) industry is an excellent example. Beginning in 2020, China’s car exports witnessed explosive growth, and by 2023, the country had overtaken Japan to become the world’s largest car exporter. Domestic, independent car brands have risen strongly, significantly surpassing joint-venture brands' sales. Over the past three years, the share of NEVs in passenger car sales has surged from less than 5% at the beginning of 2020 to 45% today.
Within just three years, China's automotive industry has achieved a significant leap forward. This rapid progress is closely aligned with the sharp rise in car exports and the ascent of domestic brands surpassing joint ventures, making it a highly successful case.
The success of China's NEV industry is inseparable from the supportive policies implemented over the past decade. These policies have covered all aspects, from initial industry planning to production, consumption, and infrastructure development. However, from the perspective of other countries, China's successful experience has already become a "threat," prompting some to take countermeasures.
For instance, in April of this year, the European Commission released a report over 700 pages, listing various Chinese policies supporting the NEV industry, such as purchase subsidies, the dual-credit system, incentives for new energy production, and special funds. While the EU views these policies as a form of "market distortion," they are regarded as the "winning formula" for developing China’s NEV industry.
I believe that both in theory and in practice, the state should intervene in industrial development. Industrial policy is not only necessary but also effective.
Fourth, government revenue should be actively redistributed to the people.
The Chinese government holds significant assets. According to 2018 data, state-owned enterprises (SOEs) accounted for 52% of the total assets in the corporate sector, with an even higher proportion in the financial industry. This vast control over assets means that the returns generated by these assets ultimately flow to the government. In addition to tax revenue, the government also gains substantial income from returns on its extensive asset holdings. Regarding national income distribution, the share of GDP allocated to household income is only 60%.
[Note: The total assets of all SOEs as of 2018 are 475 trillion yuan, according to a 2019 State Council report to the National People's Congress Standing Committee. The total assets of all Chinese corporate entities as of 2018 are 914 trillion yuan, according to China's Fourth National Economic Census conducted in 2018 and released in 2019. 475/914=52%.]
Since the government controls a significant amount of income-generating assets, the balance between supply and demand in the market cannot be achieved if this money is not spent. In a modern economy, developing production is crucial, but finding demand for that production is equally important. Demand is supported by income or purchasing power, and it is only through spending real money that demand can be created. For a country, total output equals total income. As Thomas Malthus pointed out over 200 years ago, "A nation must certainly have the power of purchasing all that it produces." However, in reality, while total purchasing power may seem sufficient, there is often a lack of effective demand.
In China, total purchasing power is distributed among different economic entities according to the income distribution structure. During this process, a mismatch may arise between the power and the will to spend: those willing to spend lack purchasing power, while those with purchasing power may be reluctant to spend. This mismatch can lead to insufficient aggregate demand or insufficient effective demand in the economy.
Given that the government holds significant assets and claims a portion of the national income, there are two ways for the market to achieve a balance between supply and demand: the first is for the government to transfer its income to the private sector, enhancing the private sector's ability to generate effective demand. The second is for the government to retain its income but be responsible for creating effective demand.
If the government does not transfer income to the private sector, it becomes the "primary spender" responsible for driving demand. In recent years, the lack of effective demand in China can, in my view, be attributed to the government failing to return income to the public while also not actively spending it itself. This has disrupted the circulation of the national economy, resulting in a persistent shortfall in effective demand—a problem that continues to worsen even today.
A fundamentally flawed viewpoint advocates for the government not to intervene in the market, arguing that government spending crowds out private demand and, therefore, the government should reduce spending and its intervention in the market. In my view, those who hold this perspective are well-intentioned but misguided. They fail to recognize the unique characteristics of China's income distribution structure.
Conclusion
How should the relationship between the market and the government be handled? I believe it requires a case-by-case analysis, adhering to the principle of seeking truth from facts. It is inappropriate to define this relationship using abstract doctrines from Western economic science rigidly.
The market provides the foundation for economic activity, while the government serves as a guide, regulator, and participant in the market. Particularly when the government commands significant income, it inevitably participates in market activities.
To evaluate whether the relationship between the government and the market is appropriately managed, a useful standard can be the "Three Benefits" [raised by Deng Xiaoping] — whether it benefits the development of productive forces, China's overall strength, and helps to improve the people’s living standards. In recent years, there have been both positive examples, such as the rise of the NEV industry, and negative cases, such as handling local government debt, in managing the relationship between the government and the market.
An appropriate relationship between the market and the government must align with China’s existing ownership structure and income distribution framework. Market participants' influence is fundamentally tied to their income—the higher their income, the greater their ability to influence the market. However, if market participants cannot translate their income into effective demand, this will result in insufficient effective demand, which can, in turn, trigger other economic problems.
The spending approach of a government that holds significant revenue should differ from that of private entities. Government fiscal expenditures should not primarily focus on micro-level returns but should prioritize social benefits. In my view, government finances should address tasks that private entities are either unwilling or unable to undertake, such as building bridges, constructing roads, and other infrastructure projects that benefit society as a whole. An example is the development of high-speed rail in the past, where the projects themselves had relatively low direct returns.
At the current stage, I advocate for the government to take a more active role in such endeavors, providing robust support for the sustainable development of China's economy rather than withdrawing entirely from the market. As previously mentioned, a government withdrawal does not necessarily improve market conditions - the large revenue controlled by the government would lose its spending channels, ultimately leading to insufficient aggregate demand or overcapacity.
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