Category / Economics

by Andrew

China’s size matters. But do we understand just how it matters?

After many years of working on China, I can still be surprised by just how big it is. It’s simple to say “China is huge,” but harder to really think through what it means. Nonetheless, a lot of people seem to think that size does not matter in any fundamental sense–the example I have in mind is the gent who years ago told me that “China is just Japan 20 years later and 10 times bigger,” which in fact is a surprisingly powerful rule of thumb. But I have to say that I suspect that some things do work differently in China because of its size, and that this is not well understood because we have no comparable examples to work with. We might call this the view, sometimes attributed to Stalin, that “quantity has a quality all its own.”

This question came to mind again after I read some interesting comments in a recent paper by the excellent Carsten Holz, the world’s foremost expert on Chinese statistics as well as a generally very thoughtful guy. The paper is not mostly about this question of size but he discusses it in passing:

China’s size is a new phenomenon in the study of developing economies. South Korea tried to develop a broad industrial base but soon began to specialize. Taiwan quickly abandoned plans for broad-based economic growth and focused on developing areas of comparative advantage, in many instances serving niche markets around the world. However, for China there are as yet no signs of significant specialization.

Across virtually all industries in China, the optimal firm size—the firm size with lowest per-unit production costs—is below market demand. I.e., there is sufficient market demand in every sector of the economy for several firms to co-exist and compete. The prospect of historically unprecedented domestic market size may yet lead to innovations in optimal firm size at lower per-unit production costs than hitherto experienced around the world.

Viewed from an international perspective, focusing on comparative advantage makes little sense for China: world demand may simply not be big enough to support any substantial degree of specialization in China. For example, for some electronics products China may already be the dominant world supplier, without, however, the electronics manufacturing industry dominating the Chinese manufacturing sector. In this case, world demand has driven specialization in production by China, except that in the Chinese economy the resulting degree of specialization is barely noticeable. As a result, one can expect to see ongoing investment across virtually every sector of the Chinese economy.

I found this a very striking idea, as one of the (many) things about China’s economy that has puzzled me in recent years is the apparent lack of specialization in its exports. There was fairly dramatic structural change in China’s exports up until about 2007, but since then the export structure has been largely stable. Exports have been growing, and China’s global market share has been rising until very recently. So China has generally been steadily becoming a more successful exporter. But as this has happened it has not shown much sign of becoming more specialized in particular types of products, which is usually one of the things that happens in countries that are successful exporters.

I had speculated that global demand was a limiting factor here: in the aftermath of the financial crisis, global demand for the kinds of things that China wants to specialize in–capital goods and equipment–has probably not expanded rapidly enough for China to have exported a lot more of those goods. But perhaps, as Carsten suggests, the issue is more fundamental, and one we have not really encountered before: China’s export industries might already large enough, relative to total world demand, that even a very successful export performance will not show up as much specialization. This is one to ponder further.

export share

Update. Here is a more precise measure of export specialization — a simple Herfindahl-Hirschman index of concentration, calculated at the 4-digit HS level (it’s the sum of the squares of the share of each product in the total). This actually shows export concentration has been bouncing around in a range since around 2003-04, so it looks less like a cyclical post-crisis phenomenon.

HHI-exports-product

by Andrew

What will China do about its zombie companies?

One of the more interesting developments in official Chinese discussions about the economy has been the appearance of the term “zombie companies”; Premier Li Keqiang himself has repeatedly used the term. It’s a loose shorthand for a problem that everyone knows about but is difficult to precisely define: money-losing companies that seem to stay alive far longer than economic fundamentals warrant. This problem is particularly acute in the commodity sectors: a global supply glut has driven down prices of iron ore and coal to multi-year lows, levels where China’s relatively low-quality and high-cost mines have difficulty being competitive. And yet they continue operating despite losing money, because it is easier to keep producing than to completely shut down. An excellent story this week in the China Economic Times on the woes of the coal heartland of Shanxi quoted one executive saying, “If we produce a ton of coal, we lose a hundred yuan. If we don’t produce, we lose even more.”

The incentive problem is very clear. If many companies shut down, output would fall and prices would rise, and the remaining companies would be more profitable. However every company wants to be one of the companies that is left standing rather than one of the companies that shuts down, and so they do everything they can to continue operating. They can also usually count on help from banks and local governments, who want to avoid the financial and social impact of a large employer closing. This is why there are increasing calls for the central government to break the logjam and organize the closure of excess capacity that market mechanisms should be producing. Indeed, I translated on this blog a very interesting proposal from the State Council’s Development Research Center on how to do exactly that.

The fact that top leaders are now talking openly about zombie companies could indicate some progress on this issue. So here’s another relevant translation: a recent interview with Feng Fei, a senior industrial official. Feng is also one of China’s top scholars of industrial policy, and in fact spent many years at the DRC. In October he was elevated to one of the vice-minister jobs at the Ministry of Industry and Information Technology, which has bureaucratic responsibility for most of the sectors with lots of zombie companies. His interview with Caijing magazine is short but to the point. He diagnoses the problem and its consequences very clearly, but hedges a bit when asked what the government is going to do. However he seems to indicate that the current preference is to deal with zombie companies by encouraging stronger companies to take them over–which I think is not as good a solution as the one the DRC has already proposed.

Reporter: Why is the exit of “zombie companies” being discussed now? What is the background to this question?

Feng Fei: There is not yet a consensus view about “zombie companies.” My understanding is that “zombie companies” refer to companies that have been losing money for a long time, and which have no hope of turning around or smoothly exiting the market. Currently the problem of “zombie companies” is very prominent, and this is related to three major issues in the economy.

First, China’s economic growth has entered a “new normal.” Downward pressure on the economy has increased, and the external environment for business is getting tougher. There are some companies whose technology, management and so forth are relatively poor, and who are finding it difficult to adapt to the new situation and to market changes, and as a result have fallen into serious trouble.

Second, there is serious excess capacity in some industries, resulting in a continuous decline in product prices and a fall in corporate profits. There are some sectors in which all companies are losing money, and operations are very difficult. For instance, in the third quarter of this year, the steel industry’s profit margin on sales was only 0.05%, and the sector’s total profits declined 97.5%; nearly half of the companies in the sector are loss-making.

Third, the market system is not robust: there are still some institutional obstacles that result in “zombie companies” finding it difficult to exit according to market rules.

Reporter: In more specific terms, what harm do “zombie companies” bring to China’s economy?

Feng Fei: The existence of a large number of “zombie companies” hinders China’s economic transformation and the upgrading of its industrial structure, and also increases macroeconomic risks.

First, these companies are holding on to a lot of resources, hindering the effective resolution of excess capacity. “Zombie companies” have low profitability, but take up a lot of land, capital, energy, labor and other resources, and prevent these resources from flowing to more profitable sectors, resulting in a serious waste of resources. You could even say that if “zombie companies” do not exit the market, the problem of excess capacity cannot be fundamentally solved, and it will be very difficult to achieve structural adjustment and industrial upgrading. Only if enough companies exit will there be enough companies entering.

Second, it undermines the market principle of survival of the fittest. Because of social stability considerations and other issues, there are efforts to preserve “zombie companies” and give them blood transfusions. This results in unfair competition, and could even cause a Gresham’s Law phenomenon [in which the bad drives out the good].

Third, it may lead to financial risks. “Zombie companies” have a lot of debt, which if not dealt with in a timely manner will result in an increase in banks’ non-performing loans. When you add in the complex chain of inter-enterprise debt, the problem becomes serious, and could lead to systemic risk. Therefore the State Council is paying great attention to this issue, and has required [us] to handle the “zombie companies” issue.

Reporter: If it is so urgent for “zombie companies” to exit the market, why has this been a difficult issue for so long? Why is it hard to establish a mechanism for market exit?

Feng Fei: “Zombie companies” can be dealt with in two ways, through market-oriented mergers and restructuring, or bankruptcy according to law. The handling of “zombie companies” will be more through restructuring, and less through bankruptcy, and will also ensure social stability. In terms of these methods, China has considered the design of the system, but has faced some difficulties and problems in terms of actual operation, and a complete system for market exit has not yet been formed.

First, in the restructuring and bankruptcy processes, there are difficulties with the placement of workers, the debt burden, and historical issues, which increase the cost of restructurings and bankruptcies. This is an obstacle to “zombie companies” exiting the market.

Second, some local governments interfere in the normal process of bankruptcy and market exit because of considerations related to preserving jobs, maintaining social stability, or the worries of banks and other creditors about bad debts.

Third, China’s “Bankruptcy Law” needs to be further clarified and refined. Although it has already been revised several times to adapt to the market economy, there are still some regulations that are more like general principles.

Fourth, in the context of increasing downward pressure on the economy, many sectors do not have a clear outlook, and firms face financing difficulties, which means they have little interest in pursuing mergers and corporate restructuring.

Finally, the current economic situation increases the risk and the consequences of corporate bankruptcies, which means that many parts of society are very wary toward bankruptcies and restructuring.

…

Reporter: According to the State Council, the Ministry of Industry and Information Technology is in charge of researching and promulgating policies on “zombie companies.” What is your plan for this work?

Feng Fei: MIIT will step up its research and survey work, find out the true situation, and figure out the major difficulties and problems in “zombie companies” exiting the market. In conjunction with relevant departments, we will research policy measures to handle “zombie companies,” improve the market, legal and policy environment, and improve the exit mechanisms for “zombie companies.”

The exit of “zombie companies” requires a proper relationship between the government and the market. The role of government is mainly to provide the necessary support for displaced workers, not to rescue companies, and to make the exit as smooth and quick as possible. At the same time, we will adhere to the policy of “more mergers, fewer bankrutpcies,” so that more exits of “zombie companies” happen through mergers and restructuring. This will result in appropriate placement of workers, reduce the impact on society, reduce the economic risk, and raise the quality and efficiency of economic development.

by Andrew

Lessons from Douglass North, plus an amazing GDP chart

I was sad to hear of the passing of the great Douglass North earlier this week (there are obituaries from the Economist, New York Times and Washington University in St. Louis, the last focusing on his teaching). While I cannot claim deep knowledge of North’s whole body of work, I loved his book Violence and Social Orders, co-authored with John Joseph Wallis and Barry R. Weingast. Amazingly enough, the book completely lives up to its subtitle: A Conceptual Framework for Interpreting Recorded Human History. North was a social scientist who, like Gellner and Levi-Strauss, aimed straight for the big questions about what modern life is; most economists do not even know how to ask those questions let alone answer them.

The book is difficult to summarize simply so I won’t try–but one of the lessons I learned from it is in fact pretty simple. The difference between good institutions and bad institutions in terms of economic growth is not that good institutions generate higher growth. Rather, countries with good institutions are flexible and better at responding to changing conditions, so they have fewer and shallower economic downturns. That results in a higher rate of trend growth over the long term. It’s a powerful and intuitive idea: the important thing is not finding the secret sauce for economic growth, but avoiding and recovering from mistakes. Here is the relevant passage:

An underappreciated feature of the different patterns of social orders relates to why poor countries stay poor. Economic growth, measured as increases in per capita income, occurs when countries sustain positive growth rates in per capita income over the long term. Over the long stretch of human history before 1800, the evidence suggests that the long-run rate of growth of per capita income was very close to zero. A long-term growth rate of zero does not mean, however, that societies never experienced higher standards of material well-being in the past. A zero growth rate implies that every period of increasing per capita income was matched by a corresponding period of decreasing income. Modern societies that made the transition to open access, and subsequently became wealthier than any other society in human history, did so because they greatly reduced the episodes of negative growth. …

Strikingly, the richest countries are not distinguished by higher positive growth rates when they do grow. In fact, the richest countries have the lowest average positive growth rates by a substantial amount. …When they grow, poor countries grow faster than rich countries. They are poor because they experience more frequent episodes of shrinking income and more negative growth during the episodes. Countries below $20,000 income do not exhibit a strong relationship between income and positive growth rates. The same is not true for the relationship between income and negative growth rates. …The poorest countries experience both more years of negative income growth and more rapid declines during those years…

All societies are subject to random and unpredictable changes in the world around and within them. Changes in external factors like climate, relative prices, and neighboring groups as well as changes in internal factors like the identity and character of leaders, internal feuds and disputes, and relative prices all contribute to persistent alterations in the circumstances with which societies must cope. The variations in the economic performance of limited and open access societies over time reflect the inherent ability of the two social orders to deal with change. …There is no teleology implied by the framework. Nonetheless, the framework illuminates why open access societies are better than natural states at dealing with change.

The latest historical economic research in fact seems to strongly support North’s thesis. The new issue of the Journal of Economic Perspectives has a nice review article on recent work compiling long-term GDP series for several European countries. There is only one chart but boy is it a doozy–just think of all the years of scholarly effort that went into creating these data series:

seven-centuries

The chart seems to very much supports North’s thesis: historically there were indeed many episodes of growth, but they were usually followed by significant reversals. At least, until the Industrial Revolution in England came along and delivered much more consistent gains. Here are the authors, Roger Fouquet and Stephen Broadberry:

The new data shows trends in GDP per capita in the key European economies before the Industrial Revolution, identifying episodes of economic growth in specific countries, often lasting for decades. Ultimately, these periods of growth were not sustained, but they noticeably raised GDP per capita. It also shows that many of these economies experienced periods of substantial economic decline. Thus, rather than being stagnant, pre-nineteenth century European economies experienced a great deal of change. …

The paper tentatively finds that the likelihood of being in a phase of growth increased and the risk of being in a phase of decline decreased in the nineteenth and twentieth centuries. …Between the fifteenth and eighteenth century, there was an average of two economic downturns per country per century, while the nineteenth and twentieth centuries experienced less than one economic downturn per country per century. In the fifteenth and sixteenth centuries, economic downturns occurred about 8 percent of the time; in the seventeenth and eighteenth centuries, they were experienced 4–5 percent of years; and, in the nineteenth and twentieth centuries, downturns occurred 2–3 percent of the time. Thus, there appears to have been a modest reduction in the likelihood of experiencing downturns over the centuries from the fifteenth century. …Explaining the source of these differences could prove to be important for understanding how economies managed to generate sustained economic growth.

Looks like North was onto something.

by Andrew

The political history of China’s economic growth targets

Growth targets are back and stronger than ever in China’s next Five-Year Plan, for 2016-2020. The plan itself is not finalized–the government has just published its “suggestions” for the final document–but it is pretty clear that the main thrust has already been decided. One of the most striking points in the official narrative is the strong emphasis on maintaining a high rate of GDP growth; to me, unrealistically high. Previously, there had been much discussion about abandoning the GDP growth target in the five-year plan, or replacing them with other indicators more directly related to household welfare (maybe China could even do something crazy like target inflation and unemployment). In the event we seem to have an even stronger emphasis on growth targets–the question is why? To start with, here’s Xi Jinping himself explaining the plan (my translation from the Chinese):

The draft suggestions put forth a goal of maintaining medium-high speed economic growth for the next five years. The main consideration is that in order to achieve the goal for 2020 of doubling our 2010 gross domestic product and per-capita rural and urban incomes, we must maintain the necessary growth rate. In order to double GDP, the bottom line for the average economic growth rate for 2016 to 2020 is 6.5% or higher. … Major domestic and foreign research organizations all think that in the Thirteenth Five-Year Plan period our country’s potential economic growth rate is 6-7%. Taking everything into consideration, it is possible for our country to maintain growth of about 7% in the future, but there are numerous uncertain factors.

It’s interesting how Xi presents the growth target as just a necessary consequence of another, more important goal: doubling 2010 GDP by 2020. And indeed there is no problem with his arithmetic: given how much the economy has grown since 2010, to double that level in 2020 requires annual growth of at least 6.5% after 2015. The GDP-doubling target is itself the specific expression of a general slogan: to make China a “moderately prosperous” (xiaokang) society by 2020. Xi has emphasized this target as one of his “two centenary goals“: achieving prosperity by the 100th anniversary of the Party’s founding in 2021, and achieving modernization and national revival by the 100th anniversary of the founding of the People’s Republic in 2049. Official propaganda under Xi has made a big deal out of these two centenary goals, but in fact they are not that new, and indeed were inherited from previous leaders. Xi’s immediate predecessor, Hu Jintao, said in his speech to the 18th Party Congress in 2012:

We need to have a correct understanding of the changing nature and conditions of this period, seize all opportunities, respond with cool-headedness to challenges, and gain initiative and advantages to win the future and attain the goal of completing the building of a moderately prosperous society in all respects by 2020. Basing ourselves on China’s actual economic and social development, we must work hard to meet the following new requirements while working to fulfill the goal of building a moderately prosperous society in all respects set forth at the Sixteenth and Seventeenth National Congresses of the Party. The economy should maintain sustained and sound development. Major progress should be made in changing the growth model. On the basis of making China’s development much more balanced, coordinated and sustainable, we should double its 2010 GDP and per capita income for both urban and rural residents.

But as Hu emphasized, this was not a goal that he came up with himself–it was one set by his predecessor Jiang Zemin. In 2002, at the 16th Party Congress, Jiang said:

An overview of the situation shows that for our country, the first two decades of the 21st century are a period of important strategic opportunities, which we must seize tightly and which offers bright prospects. In accordance with the development objectives up to 2010, the centenary of the Party and that of New China, as proposed at the Fifteenth National Congress, we need to concentrate on building a well-off society of a higher standard in an all-round way to the benefit of well over one billion people in this period. … On the basis of optimized structure and better economic returns, efforts will be made to quadruple the GDP of the year 2000 by 2020, and China’s overall national strength and international competitiveness will increase markedly.

This was actually a more precise formulation of the growth goal than Jiang had given previously. Here is what he said at the 15th Party Congress in 1997:

Looking into the next century, we have set our goals as follows: In the first decade, the gross national product will double that of the year 2000, the people will enjoy an even more comfortable life and a more or less ideal socialist market economy will have come into being. With the efforts to be made in another decade when the Party celebrates its centenary, the national economy will be more developed and the various systems will be further improved. By the middle of the next century when the People’s Republic celebrates its centenary, the modernization program will have been accomplished by and large and China will have become a prosperous, strong, democratic and culturally advanced socialist country.

There you have it: the original formulation of Xi’s two centenary goals was actually made in 1997. But it is also clear that the history goes back even further, as those goals were very directly inspired by a previous declaration from Deng Xiaoping himself, in remarks on April 30, 1987:

Our goal for the first step is to reach, by 1990, a per capita GNP of US$500, that is, double the 1980 figure of $250. The goal for the second step is, by the turn of the century, to reach a per capita GNP of $1,000. When we reach that goal, China will have shaken off poverty and achieved comparative prosperity. When the total GNP exceeds $1 trillion, the national strength will increase considerably, although per capita GNP will still be very low. The goal we have set for the third step is the most important one: quadrupling the $1 trillion figure of the year 2000 within another 30 to 50 years. That will mean a per capita GNP of roughly $4,000 — in other words, a medium standard of living. That target may not seem high, but it is a very ambitious goal for us, and it won’t be easy to achieve.

We are now confident that we can attain our first goal ahead of schedule, this year or next. That doesn’t mean it will be easy to reach the second goal, but I think we can do it. Our third goal will be much harder to reach than the first two. Our experience over the last eight years or so shows that the road we have taken is the right one. But it is only after the third step that we shall really be able to show the superiority of socialism over capitalism — that’s something we can’t prove at the moment. We shall have to work hard for another 50 or 60 years. By then, people of my age will be gone, but I have no doubt that the younger generations will reach the third goal.

(Deng also made a slightly different statement of those goals on April 26 of the same year). This formula became known as the “three-step” development strategy, and Jiang’s version in 1997 as the “new three steps.” Deng also originated the term xiaokang, now conventionally translated as “moderately prosperous,” which he chose to convey a modest aspiration for ordinary people to have a better life.

This historical context makes it easier to understand why these GDP targets are politically so important: they are a way by which successive Chinese leaders have tied themselves to the legacy of Deng Xiaoping, and thereby increased their own legitimacy. By saying he is committed to the goal of doubling GDP by 2020, Xi Jinping makes it clear that he is carrying on the weighty tasks undertaken by his predecessors, and is continuing the great legacy of the Communist Party. In other words, there is no real economic justification for picking a certain rate of GDP growth to target; it is all about the political symbolism (all that stuff you read about China needing to grow 7% a year to prevent social unrest is total nonsense).

This kind of political symbolism was a mostly harmless feature of Chinese politics in earlier years, because the growth potential of the economy was so high that setting these arbitrary growth targets had little impact on actual economic policy. Until very recently, there has rarely been a year in which actual GDP growth did not exceed the target by a wide margin. China’s problem now is that its growth potential is declining, and failing to meet the growth targets has become a real risk (indeed, a near-certainty). Reformers in Deng’s day promoted fast growth as a way to break free of the legacy of the planned economy; in today’s China, reformers worry that targeting fast growth creates too many costs, environmental and otherwise, and gets in the way of structural changes that would improve welfare over the longer term (even if few are willing to publicly challenge the view that potential growth is still 7%). So the growth targets for 2016-2020 will have a greater and more malign influence on policymaking, because they will start to actually affect decisions on a regular basis.

growth-targets

Was it inevitable for China to end up in this trap, where it is held hostage to unrealistic growth targets inherited from previous generations of political leaders? Of course not. If you look at Deng’s original formulation, it was quite vague about the longer term: he did call for quadrupling the GDP of 2000, but said it might take anywhere from 30 to 50 years. When Jiang initially set his goal for the Party’s centenary in 2021, he did not say that GDP had to exactly quadruple by that date, only that it should rise substantially. It was only later on that Jiang formalized the goal into a quadrupling of GDP over the 20-year period. Even then, his successors could have easily shifted the rhetoric: for instance, retaining the goal of achieving “moderate prosperity” by 2020, but dropping the precise definition in terms of GDP. But China’s leaders have been so desperate to gain the political legitimacy that comes from a link to Deng’s legacy that they have been unable to make even such modest changes.

by Andrew

What if innovation requires irrationality?

I recently finished The Knockoff Economy: How Imitation Spurs Innovation by Kal Raustiala and Christopher Jon Sprigman, as part of my periodic attempt to educate myself on productivity issues. I decided to tackle to my to-read list from the bottom rather than the top for a change, and since this book had been sitting there for at least two years, it was the winner. It’s very good and clearly written, and a lot of their arguments have become more mainstream since it was published in 2012.

There are many interesting tidbits throughout, but one I found very intriguing came at the very end, in a coda not closely related to the main substance of the book. Here is an excerpt of the relevant section:

Conventional thinking about innovation and IP relies on the concept of a rational innovator. It assumes that innovators calculate, either explicitly or implicitly, the cost of creation versus the size of the return they will likely enjoy. A writer might anticipate a certain advance from her publisher; a musician might estimate the sales of a new song. This expected return shapes how much effort they pour into creation and what kinds of creation they pursue. Abundant research in economics and psychology, however, suggest that their judgments are often likely to be wrong—and systematically so.

As many studies have found, individuals are very bad at assessing their own future prospects. They have a pronounced optimism bias. They think they will succeed where others have not, and they heavily discount the prospect of failure. Nearly all newlyweds, for example, believe they will not get divorced, when in fact a large minority will—and often within a few years. Likewise, students wildly overestimate their likely grades, even in the face of stiff competition. Like the residents of Lake Wobegon, we all want to believe we are above average. … Optimism bias, in short, leads many innovators to think they will gain a greater return from their intellectual creations than they actually do.

Why is this important to understanding the interaction between copying and creativity? Because optimism bias likely acts as a subsidy for innovation. Creators who have an unduly strong belief in their ultimate prospects for success should be willing to invest more in their creativity. And this increased willingness to invest is likely, in turn, to lead to increased creative output as compared with a world in which creators rationally calculated the odds—odds that may include expected losses from copying.

There is another important, and related, factor that skews how innovators assess their expected return on innovation. Many contemporary markets for creative goods are what economists call “winner take all” or “tournament” markets. In these markets, a huge reward goes to a few at the very top—the superstars—while much less goes to those just below them. This dynamic is easy to see in areas like professional sports: just think about Major League Baseball, where the very best players receive enormous salaries, while those who are merely excellent languish on AAA farm teams, earning a tiny fraction of what the true stars do.

Tournament markets amplify small differences in performance into enormous disparities in reward. Given this basic dynamic, we might expect people to shy away from competing in markets like these—the risk of failure is great, competition can be very intense, and the difference between success and failure hard to determine until years of effort have been invested. Yet we see large numbers of individuals competing to become a sports star, a national politician, a CEO, or, most important for our purposes, a musician, writer, or inventor of the next huge Web concept. Many markets for creative goods are tournament-like. A hit song can yield huge sums for the right creative artist. Yet the vast majority of songs go nowhere, commercially speaking. Likewise, books and screenplays can rake in enormous revenues if they are truly successful, but New York and Los Angeles are awash in the tens of thousands of authors who tried and failed. …

Like optimism bias, tournaments induce more investment than is rational. So both optimism bias and tournament markets push innovators toward high levels of innovation. …The important point is that both of these effects exaggerate anticipated benefits. And it follows that exaggerated expectations of benefit will tend to keep innovation buoyant, beyond what a rational calculation of return would predict.

In other words, pursuing innovation to some extent depends on having irrational expectations about the future. To me, this ties very neatly into David Graeber’s bureaucratic theory of technological stagnation: he argues that the more research is driven by corporate bureaucratic practices that require precise estimation of the outcomes and benefits of said research, the less innovation actually happens. This contention directly challenges William Baumol’s idea of the “free-market innovation machine”: that sustained rapid economic growth is possibly precisely because innovation can be turned into a routine organized activity, and does not have to depend on random flashes of insight.

It does seem clear that once innovation becomes a routine corporate activity with a budget and cost-benefit analysis, then that cost-benefit analysis should be more accurate than what individual people do in their heads with all the usual cognitive biases and errors. But if the incentive to innovate depends on systematically over-estimating the potential benefit of innovation, then doing an accurate cost-benefit analysis will not in fact be a good thing. It may lead to less wasted effort at the individual or firm level, but could also mean less innovative activity in aggregate.

To be clear, this is not at all what Raustiala and Sprigman argue–to the contrary, they think that the irrationality of innovation in fact makes it more resilient to bad regulation or intellectual property-rights violation, and therefore is a reason to be more not less optimistic about the future of innovation. And I don’t completely believe the bureaucratic theory of technological stagnation either (Baumol is a genius and more likely to be right than Graeber). It is worth thinking about though.

by Andrew

The Russian origins of Chinese economic reform

DXP   

One of the more interesting arguments in Pantsov and Levine’s new biography of Deng Xiaoping is that China’s post-1978 economic reforms should be understood not as a rejection of Soviet-style Communism, but as a development of a different tradition of economic thought within Communism. Specifically, they argue that many of the features of the 1980s reforms were directly inspired by the “New Economic Policy” practiced in Soviet Russia in the mid-1920s. Here’s what they say in the introduction:

The theory of reform and opening that Deng developed several years after Mao’s death, in the late 1970s and early 1980s, did not originate with him. It was rooted in the Russian Bolshevik Nikolai I. Bukharin’s interpretation of Lenin’s New Economic Policy aimed at developing a market economy under the control of the Communist Party. Deng studied this concept in the mid-1920s in Moscow during his sojourn as a student at a Comintern school and began implementing it as soon as he solidified power.

The central idea of the NEP, so far as I can make out, was to back away from full-scale state ownership and planning, and allow market transactions and some private enterprise in the context of an economic system still dominated by the Communist Party. This is indeed pretty much the formula that Deng pursued after he came to power. And of course Deng, who studied in Moscow during the period of the NEP, would have been well aware of these ideas. He even mentioned the NEP in passing in August 1985 in a conversation with Robert Mugabe:

What, after all, is socialism? The Soviet Union has been building socialism for so many years and yet is still not quite clear what it is. Perhaps Lenin had a good idea when he adopted the New Economic Policy. But as time went on, the Soviet pattern became ossified. We were victorious in the Chinese revolution precisely because we applied the universal principles of Marxism-Leninism to our own realities.

Pantsov and Levine somewhat misleadingly paraphrase this quote as Deng saying that “he openly acknowledged that ‘perhaps’ the most correct model of socialism was the New Economic Policy of the USSR.” Part of what Pantsov and Levine are trying to do with this, as in much of their book, is to counterbalance some of the hagiography of Deng and cut his historical status down to size. But I’m not sure how much difference it makes to our evaluation of Deng where he got his ideas from–everybody gets their ideas from somewhere, and we usually expect national political leaders to be good decision-makers rather than original intellectuals (that’s a staff job). And it was common for many of China’s early economic reforms to be justified by references to canonical Communist texts (here’s another example), which made them easier to digest.

Nonetheless, it is clear that there was a groundswell of interest in Bukharin and the NEP during the early reform period, an interesting phenomenon of which I was previously unaware:

In 1981 Chinese scholars began publishing their own articles on Bukharin. Over a period of two years, no fewer than thirty-six articles appeared in various PRC journals on his life and works. One of the first articles, by the historian Zheng Yifan, a 1959 graduate of Leningrad University, which was published in the first issue of Shijie Lishi (World History), caused quite a stir. Zheng flatly stated that Bukharin was a Marxist theorist and economist, and that everything Stalin had said about him was false. In this connection, he noted in particular the truth of Bukharin’s slogan addressed to Russian peasants: “Enrich yourselves, accumulate, develop your farms.” Understandably, he did not compare this slogan with Deng’s well-known idea that it was good to be rich, but everyone knew what he meant. Naturally, the majority of articles addressed Bukharin’s economic views. Chinese social scientists recognized that they “were relevant today.” They appreciated Bukharin’s acknowledgment that socialism in the USSR was “backward in form,” his defense of prosperous peasants, his insistence that the growth of industry directly depended on the growth of agriculture, his support of the harmonious combination of planned and market regulations, and his recognition of the important role of the law of value in commodity-financial relations under socialism.

This context also I think helps us better understand the changing ideas about the economy in the first half century of the People’s Republic. The long struggle over economic policy in China was clearly not one between proponents of the planned economy and backers of a Western market economy. It makes much more sense to see it as a battle among Communists over competing interpretations of Marxism-Leninism.

Andrew Walder’s recent book China Under Mao: A Revolution Derailed, which I highly recommend, argues that Mao’s economic policies in the 1950s were based on an early and extreme interpretation of Marxism-Leninism. But Mao’s ideas were already viewed as outdated by other Communist states, who were already moving toward a less rigid version of the planned economy. Deng Xiaoping, and other figures such as Chen Yun, were clearly part of a different tradition within Communism that was less strictly ideological and more concerned with improving living standards. Deng and other reform-era leaders were not Western liberals in disguise working secretly within the system; they were committed Communists who argued for the superiority of their version of Marxism.

by Andrew

Mapping China: Which provinces are most dominated by state-owned firms?

The answer I’ve come up with is not quite the one I expected, but it does make sense I think. Beijing is number one, naturally–it’s the place where all the major national state-owned enterprises are headquartered, and SOE influence is inescapable. But after that easy one, anecdotal impressions do not provide much of a guide. According to my scoring system, the provinces where SOEs have the biggest economic weight are the wealthy coastal municipalities, and the far western provinces. In other words, SOEs dominate both the richest and poorest provinces in China, and play a relatively lesser role (though still a large one) everywhere else.

It is interesting that this pattern does not map that well onto the geographic distribution of China’s economic slowdown. Liberals like Sheng Hong of the Unirule Institute argue that the slowdown is caused by the poor performance of SOEs. At least in terms of simple correlations, that does not look to be totally true–indeed the provinces with a high SOE influence score are among those where economic growth has held up relatively better. This is probably because spending by SOEs is one of the main channels the government uses to support growth (it’s the Chinese replacement for countercyclical fiscal policy, which otherwise they don’t do much of).

The provinces where growth has been really terrible are those whose industrial structure is most exposed to the downturn in housing construction, which mainly means places with big mining or steel sectors. Since a lot of mines and steel mills are in fact privately owned, these provinces are actually not as SOE-dominated as some others. I think the poor western provinces have such high SOE influence scores because they do not have much indigenous industry, and are heavily dependent on investment projects funded by the central government and SOEs.

I would not let SOEs are completely off the hook, though it is tricky to disentangle the effects of state ownership and the effects of industrial structure. You could argue (and I probably would) that SOEs tend to make poor investment decisions and thus contributed to excess capacity in the steel and mining sectors, making the slowdown worse. But this argument is complicated by the fact that the provinces with the most resilient, service-driven economies–Beijing and Shanghai–are also incredibly state-dominated. So there’s not a straight correlation between more SOE influence and worse economic outcomes. At first glance, the relative outperformance of services against heavy industry seems to be a bigger effect than the outperformance of private firms against SOEs.

Anyway, food for thought, and further work. And now to the fun part–the map! I use my hex grid map of China in order to show the province names more clearly, and not diminish the importance of the three coastal municipalities which are geographically small but economically large.

hex-map-provincial-SOE-rank-readable

The three indicators I used to compute the SOE economic influence score are: state-owned enterprises’ share of gross industrial output value (as of 2011), state-owned enterprises share of fixed-asset investment (as of 2012) and the ratio of local state-owned enterprises’ assets to provincial GDP (as of 2013). For each indicator I use the most recent data available, but these ratios do not change dramatically over time. I normalized the reading of each indicator and then summed the normalized scores for each province to generate the overall score and ranking.

If I had to pick one indicator out of the three as the most reliable, it would be the SOE share of fixed-asset investment. The SOE share of industrial output (which I mapped previously) does not account for the important role SOEs play in the service sector, which is particularly important in places like Beijing, while the assets of local SOEs would not capture activity by central SOEs which is quite significant in some places. The northeastern provinces, which are generally viewed as having very state-dominated economies, rank very high in terms of the SOE role in industry, but not as high in terms of the broader indicators–which is an interesting corrective to the standard regional prejudice. The complete ranking of the provinces is below:

Top 10   Middle 11   Bottom 10  
Beijing 1 Shaanxi 11 Hunan 22
Qinghai 2 Shanxi 12 Jilin 23
Gansu 3 Heilongjiang 13 Zhejiang 24
Tibet 4 Ningxia 14 Jiangxi 25
Guizhou 5 Guangxi 15 Guangdong 26
Chongqing 6 Anhui 16 Liaoning 27
Yunnan 7 Sichuan 17 Hebei 28
Xinjiang 8 Inner Mongolia 18 Jiangsu 29
Shanghai 9 Hainan 19 Shandong 30
Tianjin 10 Hubei 20 Henan 31
Fujian 21