Goal and Process

Yingyi QIAN

Perspectives, Vol. 2, No. 2

I. Three Notable Areas

Two decades have passed since China first started economic reforms. As the third ten years begin unfolding, China should pay special attention to three geographic areas for their unique experiences. First is the market economy in developed countries, of which the United States is the irrefutable leader. Apart from markets and capital, these economies enjoy the most advanced technology, especially in the field of information technology. In particular, led by phenomenal development in the information industry, the U.S' achievement of sustained growth without inflation is worth our research effort.

Second, Asia, and especially the Asian financial crisis, presents unlimited sources for economic research. For example, Indonesia, the fourth largest country in population and one of the most populous in our peripheral nations, has been a role model for economic development by the World Bank and has indeed achieved impressive progress (among other things, it has done a better job than China in reducing poverty). However, its instant economic collapse and enormous political instability up to date is thought provoking. Another example would be Japan, whose growth drove the U.S. into panic in the 1980s, yet it is experiencing a consecutive ten years of recession.

Third, the so-called transitional economies that have direct relevance to us. There are around thirty countries that fall into this category and they claim one third of the world population (including China). They used to have the same economic system as we did and some of our reform schemes were once inspired by early reforms in Eastern Europe. On the other hand, we are actually competitors in the transition toward market economy. We may learn quite a lot from the experiences of those countries, for example, that of Russian economic and financial crisis.

I will focus on transitional economies in this essay.

II. Overview of Transitional Economies

It has been twenty years since China started the reforms and ten years for the Eastern Europe since 1989. What are the real processes of their development and how do people evaluate them? It was claimed only one year ago that the East European transition was soon to be completed, but in August of 1998 Anatoly Chubais, a major reform architect of Russia, said instead, "We used to think the transition toward market economy needs four to five years and at most eight years. It is clear by now that reform will take decades." Indeed, transition takes a long time.

There are about thirty transitional economies in Europe and Asia, claiming one third of the world's population. The largest five economies by population are: China (1.2 billion), Russia (150 million), Vietnam (70 million), Ukraine (50 million) and Poland (40 million). None of the other countries has more than 25 million people. In terms of total national GDP, the three largest countries are China, Russia and Poland, which represent Asia, the former Soviet Union and Eastern Europe, respectively. Judged from economic growth, the best performing transition economy is China, and Poland is the best in Eastern Europe up to today. Moreover, up to 1997, Poland is the only one among all transitional economies in Eastern Europe and the former Soviet Union that had the official GDP reached and exceeded the 1989 level. Russia has grossly under-performed. Despite some observed improvement in 1997, 1998 would still see negative growth.

III. Recent Changes in the Research on Transition Economies

There has been a fundamental change in the research of transition economies in the past few years from simplistic formularization of stabilization, liberalization and privatization toward studies on institutions and analysis of their impact. Such a simple formula is sometimes called "Washington Consensus" and the new trend, "Post Washington Consensus". Yet not everyone agrees with this labeling. The change from simple formularization to institutional focus and microeconomic improvement has largely stemmed from Russia's and other Eastern European economies' disappointing performance after following this formula. People started to suspect that the "Washington Consensus" is at least insufficient and inadequate.

What has gone wrong with this traditional approach? Economists might have made two fundamental mistakes.

IV. The First Fundamental Flaw in Traditional Economic Thinking

First of all, economists' understanding of the operation of a real market economy is fundamentally inadequate.

Economists think that they know how the market economy operates when talking about transition. Indeed, economics has excellent research on explaining price mechanisms. However, systematic research did not begin until recently on the functions of market institutions, incentive mechanisms, the influence of political economy, and especially on how history is relevant. Therefore, some economic historians say that economists have only limited knowledge about the operation of the market economy. To a large extent, most economists, perhaps except for economic historians, take these institutions for granted. Douglass North said in 1997, "only few western economists are aware of the significance of institutions in creating the market while others take them for granted." For example, information asymmetry is absent in Arrow-Debreu's General Equilibrium Model where private property is an assumption. The standard textbook for undergraduates on finance and banking by Frederic Mishkin of Columbia University did not incorporate discussion on financial crisis triggered by moral hazard until recently. During a seminar that I went to in September, when asked for comment on this issue, the author said he himself had "just learned about moral hazard." In the market economy, the completion of transactions depends on the protection by and the implementation of the law. However, in most cases, the deterrence power of the law is already significant enough and no actual legal actions are needed. As in the game theory, one would not reach the "off-equilibrium path:" when one knows that if one violates the law he would be published, one does not have an incentive to violate the law. The importance of law and institutions in most developed market economies are often underestimated. And in transitional economies, these institutions simply do not naturally exist. Transition is exactly the process by which these institutions are created to support many "off-equilibrium" points that are not easily detected. To be sure, such legal institutions do not exist in transitional economies. Though Lawrence Summers and Stanley Fisher mentioned the necessity of the rule of law in transitions in their 1990 paper, the significance of institutions is still not emphasized enough. Economists either ignore the importance of institutions for the market economy, or naively think that they will develop on their own.

Unfortunately, they do not. Why did Russia or the Czech Republic not achieve their goals despite the stabilization, liberalization and privatization? It has come to be recognized by many now that economists did not pay enough attention to the importance of establishing relevant institutions.

V. The Second Fundamental Flaw in Traditional Economic Thinking

A second fundamental flaw is that many economists have confused between ultimate goals of transition and the processes of transition.

And this comes naturally when the importance of institutions is ignored. Liberalization, stabilization and clearly defined property rights are ultimate goals. Even if we are clear about the goals, we still wonder about ways to achieve the goals. Robert Solow of MIT said in 1990 that no one would tell you how to make transitions. Richard Freeman of Harvard also commented that none of us knows clearly the functions of institutions in mature market economies, let alone the ways by which to establish them. Thus, even if economists know exactly where the goals lie, how to get there is another matter. Unfortunately, many western economists believe that they know the ways. However, all they suggest is "what is the goal" instead of "how to get there". For example, Jeffrey Sachs has a book titled "Poland's Jump to a Market Economy" where "jump" signals the lack of process.

Why is this issue important? People are used to labeling transitions according to final goals only. The mindset is that nothing is correct unless it matches the American model. This is problematic. For example, if a country is not as open as the United States in tariffs or capital flows, it is judged to be on the wrong track. Many people are shackled by this mode of thinking and therefore are not able to recognize that institutions in transitions are imperfect compared to ultimate goals. They do not admit that the existence of many "second-best" arrangements during transition is a major distinction of "processes" compared to "goals" and that the "second-best" naturally come with many imperfections. However, it is these second-best arrangements that usually play a pivotal role in transitions since they truly show that the starting point is distorted and that transition can only be made through imperfect institutions, political compromises and continuing history. On the contrary, seemingly perfect things may bring about undesirable results since other complementary institutions may not have been established. However, many economists not only ignore these second-best choices, but also criticize them for their imperfections.

These economists are "naïve capitalist reformers" for the aforementioned two flaws and they may hurt many transitional economies for their misunderstandings.

VI. Naïve Capitalist Reformers

Interesting enough, Janos Kornai criticized "naïve socialist reformers" in the 1970s and 1980s. They thought that markets could be simulated by the government, which replaces its direct orders by its indirect control over prices. This is known by Chinese economists as the coordination method change from "1A" to "1B." In this way, no market pricing mechanism or ownership reforms, only market simulation. Kornai admitted to be a naïve socialist reformer himself when in the 1950s. Later, the Hungarian reform proved that this model simply does not work. Earlier reforms carried out in Eastern Europe failed. In this respect, neither naïve socialist reformers nor naïve capitalist reformers have done well for Eastern Europe or the former Soviet Union.

Poland is a recent star performer in Eastern Europe and some Polish economists argue that it is because the country abandoned the "shock therapy" since 1993. There are of course other opinions. But even by the most optimistic estimation, very few transitional economies would attain the level of 1989. Exceptions include Poland, Hungary and small economies in the Baltic region, all of them are actively applying to join the European Union. Most former republics in the former Soviet Union and countries such as Bulgaria and Romania are still struggling with very weak economies. As such, Poland is not able to convincingly represent all its fellows to hail the success of transitional economies, which, judged as a whole, is far from being successful.

VII. Reflections

Why did we economists mistake? Where did we go wrong?

In retrospect, even though limited in knowledge, economists that provided policy advices thought that transition was easy and they had the solution. To make matters worse, policy makers in Eastern Europe seriously believed that these advisors had the solution. History proved that this is dangerous.

However, I do not agree with the "conspiracy theory" either. What matters most to the majority economists is neither monetary nor political gains but their beliefs, theories that they would fight to defend all their life. Theories proved wrong by facts inflict unbearable sufferings on economists. For example, the economic development in Japan challenged the seemingly perfect western economics theory. As Martin Weitzman of Harvard once said, the Japanese recession in the 90s at least helped some economists regain some confidence since it showed that they were right. These economists are holding the same attitude in the case of transitional economies. Successful cases that are inconsistent to their "models" would make them extremely uncomfortable. And China is such an example.

There are of course ideological reasons. The Economist magazine is an example. Several years ago, all Russia did was good and nothing China did was right. The teen digit inflation rate per month in Russia was a great achievement while teen digit inflation rate per annum in China was horrible. China's reluctance at privatization was attacked as unfounded fear of unemployment because Russia had privatization without increasing unemployment. They were not aware that Russia's low unemployment rate was precisely a reflection of the failure of restructuring after privatization because of the "insider's control" problem.

Furthermore, economists are overly confident in theories proved to be powerful under normal conditions. For example, they regard the price theory as "common sense" in economics. However, it might be common sense in economies that have finished transition, it may not be common sense in the transition period, for example, under the soft budget constraint, raising the price might not reduce demand at all.

Yet economists always find comfort in the argument of "politics". A simple way to explain why their policies do not work is to blame the "stupid politics". Economics never fails while politics invariably does. Either because of stubborn conservatives blocked the reform, or because reformers make too many compromises. Political scientist Barry Weingast once said that economists, ironically, expect people to pursue self-interest in economic decisions and do the contrary in political decisions.

VII. On China's Reforms

Despite some attention from economists, China's reforms remain a mystery to many. Apart from ideological issues, much of China's success contradicts conventional theories. What are their reactions toward China's achievements then?

First, the data are wrong. China's growth is overestimated and so is Eastern Europe's output fall. What is implicit here is that theories would not fail and it is the numbers that went wrong. Russia's data are wrong because many growth elements were not included in official statistics and achievements of the planned economy before the reforms were overestimated. China's real growth was overstated because inflation rates were underestimated.

Second, China's issue is more of development than one of transition since China is a poor agricultural nation. As such, reforms are easier in China than those in Eastern Europe.

Third, China's high growth mainly comes from agriculture and export sectors and offers nothing new than other East Asian economies.

Fourth, China could have done even better if it had followed western advice, for example, to pursue privatization from the beginning.

Fifth, China's development is not sustainable. It either will collapse soon or is already on the verge of collapse now.

VIII. New Understanding in Transition Theory

There do exist people, however, who have recognized the challenge to mainstream economics theories posed by the Chinese experience: utilization of existing institutions to service market development, emphasis on experimentation, balancing of various interests, seeking support from the society at large, etc. All these are practical and effective approaches. China's way of "establishing" before "destroying" is indeed different from that of other transitional economies and thus worth studying. Comparing different experiences from China, Russia and Poland, many theories of "naïve capitalist reformers" are being questioned.

However, what I want to stress here is that we do not want to reverse to the old "developmental state theory." Gone is the era of simplistic choice between market and state, or between big and small government, or between capitalism and socialism. Attention should be placed on institution development and transition sequencing. The new transition theory emphasizes the following three previously neglected aspects.

First, the significance of institutions in economic transition and development as discussed above has been ignored. Second, is the issue of the political economy factor. The so-called reform politics implies that successful reforms are often those reforms that enjoy popular support and that no interest group suffers too much in the process. Economists traditionally are only concerned about efficiency, about the size, but not the distribution, of the pie. Political support means that not only the size of the pie matters but also reformers have to make sure the distributional consequences of reform. If a lot of people suffer, they will protest and reforms will not get the support needed. Russia is a good example in this regard. To get the loans from IMF, Russia had to cut down domestic government payment, which resulted in decreased income for domestic workers, who turned against the reform. Third, the role of history deserves a more significant attention. There is an issue of so-called "path dependence". A country's specific history exerts great influence on its transition. Poland is not the same as Russia and China is different from others. Economists tend to think that economics is universal and applies to all. Sure, the basic economics principles are universal, yet when we analyze transition path of a particular country, we have to be careful.

Overall, I do not consider a shift from neo-liberalism to interventionism is appealing. But we have to emphasize the significance of institutions, political economy, and history in our economic analysis on transition toward markets.

IX. China's Reforms in Retrospect: The Second-Best Perspective

Two extremes exist when evaluating China's reforms. On one extreme, all aspects of China's reforms are terrible. For example, all non-private firms are bad. Of course, it is easy to criticize China's township-village enterprises (TVEs) and other collective enterprises because they are not as efficient as formal corporations. On the other extreme, everything China is doing is unique and that is the way to go. People with this opinion do not see the fact that China is in the middle of a transition process and should not stay in the process even though some of the experiences are proved helpful. Against these two extreme views, I am expecting a third perspective. China realized the importance of institutions from the very start. Many institutions were in fact second-best choices. In fact, given the starting point and the many constraints at the time, second-best choices were well justified. On the other hand, they also left much room for improvement precisely because they are only second-best arrangements. Let me give several examples.

First, TVEs. TVEs are neither private nor state-owned enterprise and do not enjoy well-defined property rights. However, TVEs filled in gaps and contributed to economic growth immensely in the early reform. A second example is China's strict control in the financial sector. Interest rates are well under the grip of the state and foreign banks are not granted entry while foreign industrial enterprises are. These policies greatly benefited China's transition, in which China, like Russia, does not have good tax collection institutions. People do not like to pay taxes but they like to deposit their money into banks. This, combined with a low inflation rate policy, ensured China's financial stability even though it might not be a very efficient financial system. In contrast, the Russia crisis was triggered by a collapse in the country's fiscal and financial system. A third example is the dual-track price system that has been criticized by many. As a transitional device, its biggest advantage is the winning of political support at the time of its introduction. The Chinese leader said at the time "I have to take care of all interest groups." The dual-track reform protected the invested interests from potential harms. As a result, it was relatively easy to start the market track. In contrast, Hungary, before 1989, never really started the market track despite years of efforts. The dual-track price system created many economic problems, but it was a way of getting political support to start reform. Of course, it is important that the two tracks be merged soon. The fourth example is the much-criticized central-local government fiscal contract system. To be sure, such a system is a far cry from the ideal of separate tax system for central and local governments. However, just out of the traditional system featuring "eating from one big pot" at the end of the seventies, the fiscal contract system in the 1980s did a good job in ensuring stable fiscal income of the central government, motivating local governments and changing local government behavior. Some western economists have a high opinion for China's local governments' enthusiastic support for local businesses because apparently the Russian local governments do not. Why? China's fiscal contract system motivated local governments to pursue local prosperity.

No traditional economist would have suggested that China do any of these four things twenty years back. In retrospect, we can see that all these reforms maintained stability, won extensive support and contributed to growth. Therefore, they are beneficial institutions at that point of history.

X. Prospect: the Goal of Market Economy and Further Reforms

However, my next point is that the aforementioned institutional arrangements are all the second best in nature. Currently, if we agree with the goal of the socialist market economy, we should recognize that China has to continue the reform. What should be the next step? I think the top priority is to establish the basis of the rule of law. The market economy would not achieve its best potential or act up to the international standard if it does not operate within a sound legal framework. I do not think that reforms should remain at the current level. For example, TVEs definitely do not represent the best corporate governance structure. Even though the dual-track price system does not exist any more, many markets are still not open enough or free enough. Furthermore, the financial system is very inefficient. It is true that we weathered the Asia financial crisis well, but our financial system is fundamentally weak. As such, future reforms will be on a much deeper level and the most important as well as difficult part of the transition process. The new process actually started from 1994 with a few reform measures, but they are not sufficient. Even worse, over the last few years there has even been certain tendency toward regression that mistakes regulation for central control. The basic reform principle for the last two decades of decentralization and motivating local government is not wrong. The principle of the market economy is decentralized decision-making. One of Mao's legacy is his emphasis on local government's initiatives. China's success in its early reforms owed much to local initiatives. It is wrong to reverse it.

The report of the Fifteenth Congress of the Chinese Communist Party did spend much space addressing the issue of the rule of law. In my opinion, there are two aspects of the rule of law: one, the rule of law imposes the constraint on government interference and two, it also puts a constraint on individual and enterprise behavior in production and transactions. First, government behavior should be constrained. Otherwise, the harassment of endless government fees on emerging enterprises would seriously impair economic development, for example. The solution should not be just converting local fees to central taxes but be granting local taxing powers on a legal basis. Furthermore, other policy priorities, such as supporting small and medium enterprises, fighting corruption and increasing transparency are all closely related with constraints on government behavior. Under Administrative Law, government agencies can be sued for inflicting inappropriate fees. Without such a constraint on government, it would be a worse burden for enterprises if they make their financial books more transparent to the government. Therefore, I would argue that the top priority is to constrain government behavior at all levels. Second, what is the government role in business transactions? The government's role of regulation should in general be positioned to support, not to replace, the market. This is the so-called "market-enhancing" role of government, not the one of "developmental state". The former has the goal of making the market more efficient with limited regulation while the latter considers that the market is chaotic and needs government control. It is indeed a great challenge to devise a set of rules for the government to better enhance the market functions.

Some people think that China has survived the hardest time and is only one step away from success. However, this one step, which is to build the market on a solid basis of rule of law, will not be easy. A lot of things that China is doing are right, such as barring the military from doing business and striking smuggling. However, we have to remember that the functioning of a market economy is based on two things: constraints on the one hand and incentives on the other, which are comparable to the brake and the engine of a car. Without constraints, the economy will derail but without incentives there will be no growth at all. The latter is even more important than the former. Ownership reform is important, but the more significant one is the establishment of rule of law, which is key to the future success of China's economic reforms. From the rule of law perspective, impartial enforcement of contracts and public laws of anti-trust and fair competition is extremely important. For example, we have lately seen the so-called "unfair competition" when government ministries stepped out to set minimum prices in the face of falling prices. As such, the government becomes a direct player in oligarchy pricing, a disruption of the market by the government itself and should be deemed illegal under the rules of the market economy. Therefore, top on our to-do list is to establish the anti-trust law.

When we have a vision of a market economy, we will not lose our goals. If, in the next ten years, China is able to build markets based on the rule of law and a non-corrupt government that is highly efficient, we may say that China will then enjoy real success of the transition.

(The author is Professor of Economics at the University of Maryland at College Park. The Chinese version of this article was published in "Journal of Comparative Economic and Social Systems," No. 2, March 1999, Beijing.)