Economic Reforms and Constitutional Transition: Part I

Economic Reforms and Constitutional Transition: Part I

Jeffrey SACHS, Wing Thye WOO and Xiaokai YANG

(Editor's Note: This article is the first part of a two-part paper. The second part will be published in the June issue of "Perspectives.")

[Abstract: This paper investigates the relationship between economic reforms and constitutional transition, which has been neglected by many transition economists. It is argued that an assessment of reform performance can be very misleading if it is not recognized that economic reforms are just a small part of the large-scale constitutional transition. Rivalry and competition between states and between political forces within each country are the driving forces of constitutional transition. The paper uses Russia as an example of economic reforms associated with constitutional transition and China as an example of economic reforms in the absence of constitutional transition, and it examines features and problems in the two patterns of transition. It is concluded that under political monopoly of the ruling party, economic transition will be hijacked by state opportunism. Dual track approach to economic transition may generate very high long-term costs of constitutional transition that might well outweigh its short-term benefits of buying out the vested interests.]

1. Understanding Economic Transition

In a recent debate about relative merit of gradual versus shock therapy approaches to economic transition, the gradualist view was overwhelmingly dominant. This is partly due to the lack of constitutional thinking among economists. Some economists who are in favor of gradualism easily jump to the conclusions by looking only at the short-term economic effects of different approaches to transition.

The rivalry between Britain and France was an important driving force of the big bang transition of French institutions during and after the French Revolution. According to Yang (1994), the rivalry between the Chinese and Russian communists was an important driving force of the big shock to China's central planning system in the 1960s and 1970s. It is more important to investigate the driving mechanism than to study the short-term economic effects of one of the many stages of transition to constitutional rules.

In this paper, we use the inframarginal analysis of the network of division of labor to investigate economic transition. When formal models are too simple to capture the complexity of institutional evolution, we will combine this inframarginal analysis with insights from constitutional economics, new economic history, and the economics of state to address problems of economic transition.

Section Two discusses how to use the Smithian models covered in Sachs and Yang (2000) to investigate the features of the Soviet-style socialist system and the driving mechanism for economic transition. Sections Three and Four examine the relationship between market-oriented reforms and the transition to constitutional rules.

2. The Socialist System and Evolution of Division of Labor

In order to understand economic transition, we first have to address the following questions. First, why has the Soviet-style socialist system finally been rejected by most countries that adopted it? Secondly, why could such a system survive, spread, and even achieve short-run but impressive growth performance before it was finally rejected? The second question relates to a third question, namely, what are the characteristics of the Soviet-style economic system? In this section we shall address these questions. We then draw the distinction between the Soviet-style socialist system, Mao's socialist system, and Deng's socialist market system. The distinction can then be used to explain the differences in transition pattern between China, Russia, and the Eastern Europe.

The debate between Lange, von Mises and Hayek generates the conclusion that market socialism cannot work. Hungary's experiment with market socialism verifies this conclusion. However, this conclusion does not address our second question. The Soviet Union did not adopt market socialism in the 1930s and the 1950s. But not only did its central planning system survive, but it also spread to many countries after the World War II. It achieved average real GDP growth rates of 8% during 1933-1940 and 9.4% during 1948-1958, as impressive as China's growth rates in the reform era. Why couldn't von Mises and Hayek (1944) predict the short-run impressive growth performance of the Soviet-style economic system, despite their correct prediction of the long-run failure of this system? Kornai's theory of socialism and von Mises, Hayek, Friedman, Cheung and Shleifer's analysis of socialism do not address this question. The answer to this question relates to the ongoing debate about shock therapy and gradualism.

Sachs (1994), Sachs and Woo (1994), and Yang (1994) provide an answer to the above question. We shall now outline this answer, which is based on the development theories generated by Smithian models of division of labor.

As shown by the Smithian models in Sachs and Yang (2000), economic development involves evolution in division of labor. In particular, Ng and Yang (1997, see also Sachs and Yang, 2000, Chapter 15) shows that in a world of bounded rationality, the evolution of division of labor is determined by the interplay between organization information acquired by society via experiments with various patterns of division of labor, on the one hand, and individuals' dynamic decisions of experiment patterns, on the other. The tradeoffs between the information gains generated by social experiments and the costs of such experiments, and between the economies of division of labor and the transaction costs, imply that the higher the experiment and trading efficiency, the more patterns of division of labor will be experimented with and the more organization information will be acquired via the market. Since society can only learn gradually the information about the efficient pattern of division of labor, those simple patterns of division of labor are experimented with before the complex ones when individuals are short of organization information. This implies that economic development involves a gradual evolutionary process from simple patterns of division of labor to the increasingly more complex ones.

As shown in Ng and Yang (1997), however, the latecomers of economic development can mimic the efficient patterns of division of labor by jumping over many intermediate levels of division of labor if the developed countries have already found the efficient patterns by gradual social experiments. The capitalist institutions in developed countries were congenial for a great variety of patterns of division of labor to be experimented by the market. The free organization information created by capitalist developed countries creates an opportunity for big-push industrialization of the latecomers. It is possible that big-push industrialization can be carried out by a Soviet-style socialist system which lacks institutional infrastructure essential for discovering the efficient pattern of industrialization. The possibility of big-push industrialization via the imitation of the industrial patterns created by capitalist countries without the capitalist institutions is the reason for the relative success of the industrialization in the Soviet-style socialist countries in the 1930s and 1950s. It is by ignoring this possibility that Hayek and von Mises failed to predict the survival, spread and impressive short-run growth performance of the Soviet-style economic system in the middle of the 20th century.

To address the third question above, we briefly outline the characteristics of the Soviet-style socialist system as follows.

(1) By keeping a low relative price of agricultural products vis-a-vis industrial goods and controlling all firms, the Soviet system used state ownership of all firms and central planning to achieve high profit margins for the state industrial sector. The profits of state firms were allocated to mimic high savings and investment rates and support growth rates of the heavy industrial sector that were higher than those of the light industrial sector. This pattern of industrial development was created by the capitalist industrialization process. In terms of the Smithian model in Sachs and Yang (2000, Chapter 12), higher growth rates of the heavy industrial sector are generated by increases in production roundaboutness and in the income shares of the producer goods sector, which is one aspect of the evolution in division of labor.

(2) State ownership of firms and a central planning system were used by the Soviet socialists to organize comprehensive industrial investment programs, which created a large number of very specialized industrial firms when the markets for a great variety of industrial goods were absent. These comprehensive state investment programs generated a big jump in the network size of division of labor, which implied a jump in the variety of highly specialized industrial sectors. In the Soviet Union in the 1930s, these comprehensive state industrial investment programs were designed by many experts from capitalist developed countries. In China in the 1950s, similar programs were designed with the assistance of experts from the Soviet Union and Eastern Europe. These comprehensive state investment programs quite effectively utilized free organization information on the efficient patterns of division of labor and the industrial linkage network effects of division of labor. A specific case of such programs is China's program of 694 large projects and 156 Soviet-aided key projects in the 1950s, which successfully created a large industrial network of division of labor among many highly specialized firms within a short period of time, although there was no market for those highly specialized producer goods. For instance, with assistance from East Germany, a firm specializing in producing artificial diamonds used in the machine tools industry was established in Zhengzhou as one of the 156 key projects, although demands for machine tools were not enough to support a large specialized firm making artificial diamonds.

(3) The Soviet central planning authorities quite systematically imitated the industrial standardization, mass production, production line and mechanisms of checks and balances between managers, treasurers and accountants within capitalist corporations. They also mimicked the Taylor scientific management and other organization patterns and management approaches developed by capitalist firms. A mechanism of checks and balances between the industrial ministries, the ministry of finance, the state banks, the planning committee, the pricing bureau, the bureau of material distribution and other departments of the government was established by dividing the rights of disposing and appropriating materials among several different agencies. This system of checks and balances established an effective mechanism of controlling the entire economy for the central planning authorities. Top government and party officials collectively claimed the residual rights of the planning system, so that they have the incentive to maximize the residual. According to Lenin, the Soviet central planners should organize the entire economy as a large corporation. But at the top of this apparatus, there were no effective checks and balances. The party and government monopoly in establishing and operating business enterprises in all sectors is in sharp contrast to the constitutional order created in the United Kingdom in 1688 with free association (including automatic and free registration of private firms) and an independent judiciary. The British system establishes checks and balances at the top of the political arena. In contrast, the Soviet-style socialist system creates great room for institutionalized state opportunism.

(4) The Soviet central planning authorities used a set of material balance tables and an iterative procedure to match demands with supplies of goods in the absence of markets for intermediate factors. The system could closely approximate the results generated by Leontief's input-output method. However, the Leontief input-output method cannot take into account the substitutions between different inputs; it is also incapable of sorting out the final demands for consumption goods, nor can it provide effective incentive mechanisms for players to reveal private information. According to Roland (2000, Chapter 1), the equilibrium achieved through a dynamic iterative process of central planning is inefficient.

(5) The Soviet imitation of successful patterns of industrialization and internal patterns of capitalist firms, however, was realized by destroying the capitalist institutional infrastructure that generated the successful patterns of industrialization and organization in the capitalist developed world. This was the first centralized social experiment with economic institutions. The precondition for a centralized social experiment is to establish monopoly power in the sector that designs system arrangements. This was realized through violent revolution, violent infringements upon private property rights and "red terrors" in numerous purging campaigns. The lack of fair competition in the sector that designed institutional arrangements implied that the institutional arrangements that were chosen could not be efficient. Also, the Soviet-style socialist economic system was the first system that was purposely designed by a government rather than emerged from the spontaneous evolution of fair competition and voluntary trade of property rights. According to Hayek, efficient institutional arrangements can emerge only as a result of such fair competition and voluntary trade.

As Sachs (1994) suggests, the strategy of imitating the industrialization patterns of the capitalist developed economies, in the absence of a capitalist institutional infrastructure, can generate impressive short-run growth performance. However, as the potential for imitation gets exhausted or as the network of division of labor becomes increasingly more complex, the long-run costs of this strategy will outweigh its short-run benefits since this system does not have an institutional infrastructure that can create its own capacity for economic development and institutional innovations.

More generally, when a latecomer of economic development tries to catch up with the developed countries, it usually follows a reverse engineering of institutional development. Usually, the latecomer tries to mimic, first, the industrial patterns, then the economic institutions such as the organization structure of private firms, then the legal system such as corporation laws, and finally the political system such as representative democracy. It may eventually adopt some constitutional rules such as checks and balances of power and ideology and behavior norms of the developed countries. According to North (1994) and North and Weingast (1989), the original process of economic development in the United Kingdom was the other way around. Ideology and moral code determined the prevailing constitutional order, which in turn determined the political system and legal system, which then generated certain economic performance. Without an overarching political power in the international political arena, the economic performance differences between countries will generate pressure for changes in ideology and constitutional rules. North believes that changes in ideology and moral codes are much slower than changes in economic structure.

It should be noted that Mao's socialist system is substantially different from the Soviet-style socialist system. Rivalry between the Chinese and Russian communists created a kind of check-and-balance in the international political arena that involves the design of institutional arrangements. Hence, Mao's political instinct, which was sensitive to the rivalry, led him to proposing administrative decentralization in his 1956 speech "On Ten Important Relationships." The rivalry was the grand background from which the differences between the reforms in China and Russia emerged.

During the Great Leap Forward in 1958-1961 and the Cultural Revolution in 1966-1976, and after the Cultural Revolution, an effective central planning system never existed in China. Five year plans and annual plans were virtually only on paper. The success of the first five-year plan in China in the 1950s misled Mao to concluding that the success was due to the merits of the socialist system created by communists. Mao did not understand that the success was based on Russians' imitation of the capitalist economy. Hence, Mao tried to invent his own communist institutions, such as the communes and mass eating halls. Also, Mao had a strong anti-Soviet Union sentiment. He advocated for administrative decentralization against central planning, for self-sufficiency of each firm, each county and each province against specialization and division of labor, for a mass line against professionalism, for small scale, self-sufficient commune and brigade firms with indigenous technologies against large-size state firms with advanced technologies, and so on. This, on the one hand, slowed down the evolution of division of labor in China and kept rural China a traditional autarchic society. On the other hand, it created a vacuum in coordination mechanisms in Mao's China: neither the central planner nor the market could coordinate the division of labor developed in the first five-year plan. This vacuum was filled by quasi-private firms and collective firms during the Cultural Revolution, by commune and brigade firms, which are now referred to as township and village enterprises (TVEs), after 1984, and by a decentralized bilateral and multilateral bargaining system in the 1970s. Procurement fairs that implemented decentralized bargains were developed in the Mao era. Barters were very common in the fairs and sometimes commodities in short supply were used as commodity money.

Rural China was quite an autarchic society until 1978. The degree of its commercialization was 0.3 before 1978, although the first five-year plan developed a high level of division of labor in urban China by mimicking the pattern of the Soviet industrialization. This means that rural China could achieve a high level of division of labor either via commercialization or via central planning. It is easy to develop a commercialized market system from a low level of division of labor. But it is extremely difficult to develop private property rights and related markets in an economy with a high degree of division of labor developed through central planning. Reforms were easy in rural China because of a low level of division of labor. In contrast, reforms in urban China were more difficult because of a much higher level of division of labor established through central planning. However, market-oriented reforms were much easier for China as a whole than for Russia because China's central planning system was paralyzed during the Cultural Revolution. Also, Mao's industrial system was much more disintegrated and locally self-sufficient than the Soviet-style socialist system.

If an economy has developed a high level of division of labor quite successfully through centralized big-push industrialization, then the centralized planning system, which is not good for long-term economic growth, is embodied in the high level of division of labor which contributes to long-term economic growth. Since the sophisticated input and output interdependence generated by a large network of division of labor is coordinated by the central planning system, it is extremely difficult to separate the dismantling process of the central planning structure from the malfunctioning of the coordination of a large network of division of labor. There is an inertia to use central planning to coordinate the high level of division of labor if reforms take place gradually. A big push or shock therapy may be necessary to cut off the central planning coordination mechanism from the high level of division of labor. In the process, paralysis of the input-output network might be inevitable because of the high risk of coordination failure in a large, highly interdependent network of division of labor. Put another way, a well developed central planning system can be dismantled only through shock therapy, since the system itself does not have the institutional infrastructure necessary for discovering the efficient institutional arrangements during the transition from the Soviet-style socialist system back to a capitalist system.

China experienced the shock process during 1958-1961 and 1966-1970, when the central planning system was paralyzed by Mao's Great Leap Forward and Cultural Revolution, and during 1971-1976, when Mao's policy of administrative decentralization prevailed. Mao's administrative decentralization divided the ownership of state firms among the central, provincial, and county governments and communes. In contrast, in the Soviet Union, there was a uniform ownership of all state firms. Deng's regional decentralization consolidated Mao's administrative decentralization by institutionalizing the fiscal relationship between the central and provincial governments. Government revenues from taxes and state firm profits were divided between the central and provincial governments according certain division rule. In the early stage of Deng's regional decentralization, a fixed amount of provincial government revenue was delivered to the central government. In the later stage, a fixed proportion of the tax revenue was delivered to the central government. A Chinese style fiscal federalism emerges from the evolution, which provides a driving force for China's reforms in the 1990s. With the help from the World Bank, this fiscal federalism separates local government tax categories and collection institutions from those of the central government (Qian and Roland, 1998, Qian and Weingast, 1997). Deng's fiscal federalism is in striking contrast with the much more centralized fiscal relationship between the federal and local governments in Russia. This partly explains the differences in reform performance between China and Russia.

But contributions of Deng's regional decentralization and fiscal federalism to economic development should not be overstated. First, it fragments the market and promotes monopoly of local state-owned enterprises (SOEs). In other words, Deng's regional decentralization inherits the bad sides of Mao's administrative decentralization, thereby retarding the formation of the integrated national market. Lardy (1998a, p. 204) uses the automobile industry to illustrate this point. Second, China's fiscal federalism is very different from the fiscal federalism of the United States. A residential registration system which has been in place since 1954 greatly restricts the free mobility of labor and human capital. Despite recent reforms to this system, which allow migrants who do not have permanent residence in large cities to obtain annually renewable temporary residency, the migrants' position in China's large cities is not as good as that of immigrants with green cards in the U.S. Migrants in Chinese cities must pay much higher school fees for their children and a much higher price for housing than local permanent residents. In Beijing and other large cities, firms hiring migrants without local permanent residency are heavily fined by the government. Finally, China has a very centralized appointment system for leading provincial government officials. The central government regularly rotates the officials between provinces to make sure that they are absolutely loyal to the central government, especially when local interests are in conflict with those of the central government. Hence, when Deng purposely kept a weak central government for political reasons after 1989, China's fiscal federalism was more like that of the U.S. But when Premier Zhu moves to increase the power of the central government in the post-Deng era, China's fiscal system becomes very different from the fiscal federalism in the U.S.

China still had a great deal of room for big-push industrialization and imitation when it entered the reform era. The high income share of the traditional autarchic sector in China implied that it still had room to mimic the efficient patterns of division of labor in the capitalist developed economies in the absence of private property rights and markets. But the potential benefits of this strategy had already been exhausted in the Soviet Union when it started its reform program.

But China's impressive growth performance was not only due to the potential for mimicking the old capitalist industrialization patterns. A great variety of social experiments in Japan, Hong Kong, Taiwan, South Korea and other East Asian countries provided room for new mimicking strategies. The newly industrialized capitalist economies provided free information on a new pattern of industrialization through labor-intensive exports. This pattern exploited a significant differential in per capita real income between developed and less developed economies to export labor-intensive manufactured goods in exchange for capital-intensive equipments. Ethnic Chinese businessmen from Taiwan and Hong Kong brought human capital, entrepreneurial expertise, institutional knowledge and capital, which were essential for the imitation of the new capitalist industrialization pattern, to China. The Chinese government also purposely learned from Taiwan and Hong Kong's experience. For instance, the special economic zones (SEZs) were certainly a direct imitation of the export process zones and free trade zones of Taiwan and other capitalist countries. The SEZs significantly reduced transaction costs caused by tariffs and other barriers of trade. Private rights of foreign direct investors were much better protected in the SEZs than in the rest of the country. According to the theory of capital and division of labor and the theory of indirect pricing in Sachs and Yang (2000, Chapter 8), this situation implies that foreign entrepreneurs had a strong incentive to sell their entrepreneurial know-how to the host country indirectly through the institution of the firm.

But Deng's reform era shares two fundamental elements of Stalin's and Mao's socialism, which is the party's monopoly of political power and the dominance of SOEs. According to Lardy's documentation (1998), the state sector expanded in terms of the output and employment level, employment share, and level and share of received financial resources during the reform era. In the largest SEZ, Shengzhen, SOEs dominate the economy. In 1992 when many government departments were short of financial resources, they were encouraged to establish and operate lucrative businesses to subsidize their expenses. A large number of new government enterprises and businesses were established at a very high speed, and 60-90% of government departments started or continued to run commercial businesses. The government agencies use their dual positions both as regulators and law enforcers, on the one hand, and as players in the economic arena and with significant economic interest, on the other, to pursue state opportunism. For one example, a local government tax bureau once ran a restaurant and used predatory taxes to force other local restaurants to close down. For another example, a police unit currently runs a firework company and uses its power in issuing licenses to maintain its monopoly in the business. The institutional characteristics lead to institutionalized state opportunism and corruption. Economic development is still a hostage of the vested interests of the privileged class.

The most important characteristic of China's market-oriented reforms is the absence of constitutional order and the rule of law. This leads to institutionalized state opportunism, self-dealing of the ruling class, and rampant corruption. We will analyze the features of market-oriented reforms in the absence of constitutional order in Section Four.

In summary, China's impressive growth performance in the 1980s and 1990s can be attributed mainly to its low level of development at the beginning of the period, which was the result of the disastrous Maoism, and to the opportunities for mimicking the new export-oriented industrialization pattern. Deng's socialist market economy emerged and evolved from a mixture of Mao's administrative decentralization and SOEs, on the one hand, and the imitation of Taiwan and Hong Kong's new development pattern, on the other. In this sense, Deng's socialist market system is different from Lange's market socialism, from Stalin's socialism which mimicked the old capitalist industrialization patterns with instruments of central planning and the uniform state ownership of firms, and from Mao's socialism which did not copy any capitalist experience. It is possible that after the potential for mimicking has been exhausted, China's new pattern of socialism may fail to work. This happened to the Soviet-style socialism after the successful imitation of old capitalist industrialization in the 1930s and 1950s.

Misunderstandings on the initial conditions and driving forces of China and Russia's reforms generate many misleading views on the comparison between China and Russia's reforms.

The first misplaced view is the overstatement of growth performance of China by some China experts. China's broad growth performance was not better than the performance of other East Asian economies. Virtually every market economy in East Asia grew very rapidly in the past thirty years, mostly based on a strategy of rapid export growth of labor-intensive manufacturing goods. During 1986-1994, China averaged an annual per capita growth of 5.6 to 6.8 percent in PPP-adjusted GDP. Other East Asian countries showed equivalent or even higher rates of annual per capita growth in PPP-adjusted GDP over the longer period of 1965-90. They include Hong Kong (5.8%), South Korea (7.4%), Singapore (7.4%), Taiwan (6.3%), Indonesia (4.7%), Malaysia (4.5%) and Thailand (4.6%). In addition, the difference in per capita real income between China and newly industrialized countries, such as Taiwan, is still increasing.

China's official statistics overstate real growth rates too. Lardy (1998) shows that official data overstate the growth rate by at least 1-2%. According to some Chinese scholars such as Luo Shao (Economic Highlights, May 15, 1999, p. 1), the official data overstate growth rates by 2-3%. Also, Lardy (1998) provides evidence that the Chinese government purposely concealed information about the bad loans of the state banks and financial conditions of the SOEs. China's growth performance is greatly inferior to what the official data indicate. It is shown that even if China's growth rates are much higher than those of Japan, Taiwan, South Korea, the United States and Germany, the differences in per capita real income between China and these countries will still increase before 2015 due to China's very low level of per capita real income in 1979. Hence, we must pay more attention to the absolute differences in per capita income and their changes than to the differences in growth rates.

Some economists argue that China's impressive short-run growth performance indicates that the privatization of SOEs is not necessary for a successful transition. This is equivalent to the false statement that the Soviet Union's impressive short-run growth performance in the 1930s would ensure the long-run success of the Soviet socialist system. Other economists (see, for example, Qian, 1999) consider China's fiscal federalism as the major driving force behind the impressive growth performance. This may not be very convincing because the post-communist Eastern Europe as a whole is much closer to a fiscal federalism than China's centralized socialist system. The variety of institutional experiments in Eastern Europe is certainly much greater than in various provinces of China. If fiscal federalism is the most important determinant of the differences in transition performance, then it is Eastern Europe, rather than China, that should have better transition performance. Actually, as we discussed above, different initial conditions, different development stages, room for imitation and inaccurate Chinese official data together explain the differences in transition performance.

(TO BE CONTINUED)

(Jeffrey SACHS is Professor of Economics at Harvard University; Wing Thye WOO is Professor of Economics at the University of California at Davis; and Xiaokai YANG is Professor of Economics at Monash University in Australia.)