Monday, May 24, 2010

Is The Chinese Variety of Capitalism Really Unique?

A Guest Post by Vladimir Popov [1]

Because the Chinese economy did much better in the recent recession of 2008-09, there is no shortage of articles suggesting that the Chinese model is more viable and that the West should learn from China.

“We in the West have a choice - writes Anatole Kaletsky in The Times -. Either we concede the argument that China, in the 5,000 years of recorded human history, has been a much more successful and durable culture than America or Western Europe and is now reclaiming its natural position of global leadership. Or we stop denying the rivalry between the Chinese and Western models and start thinking seriously about how Western capitalism can be reformed to have a better chance of winning” [2].

“East is East, and West is West, and never the twain shall meet”? Rudyard Kipling's oft quoted words prompt a more modest question: does the Chinese economic model today differ radically from the Western model; does it really have magic properties that allow growth amidst the world-wide recession or has growth been just a stroke of luck?

Certainly the Chinese economy is no longer either centrally planned or state-owned. On the similarities with the West side we have the:

- Dominant role of the private sector - 75% of GDP is produced by non-state enterprises, including joint stock companies and individual private businesses, which are not that different from their Western counterparts;

- Relatively small share of government spending in GDP (about 20%) – lower than in all Western countries and often lower than in developing countries with similar per capita GDP;

- No longer free education and health care, and relatively high income and wealth inequalities (Gini coefficient of 45% and 64 billionaires on the mainland alone, according to the March 2010 “Forbes’ account, second in the world after the US with 403, but ahead of Russia's 62).

Differences with the Western economic model also do not seem to be all that significant:

- China has a strong, export-oriented industrial policy – mostly caused by undervaluation of the yuan leading to the accumulation of vast foreign exchange reserves. This is not without a precedent, however, since this practice was used by Hong Kong, Japan, Korea, Taiwan and Singapore at earlier stages of development);

- Land is still not private property in China and is not traded, but private, long-term transferable private leases are widespread; besides, public ownership of land is not uncommon in other countries, albeit in smaller proportions;

- China exercises controls over its capital account but, again, this practice is used by many developing countries now and was still being used by European countries just half a century ago, until well after the end of the Second World War;

- China has an authoritarian regime (which, of course, all developed countries had in the past; some of them, like Spain, Portugal, Taiwan, South Korea, as recently as three-four decades ago).

A real difference is the institutional capacity of the state.

Many formal comparisons of the similarities and differences of Chinese and Western economic models misses the most important point. The uniqueness of China is that while it looks very much like a developed country today in terms of the institutional capacity of the state, it is a developing country according to GDP per capita. Instead China should be compared with developing countries today or developed countries a hundred years ago, when their GDP was at the current Chinese level; this comparison is very much in China favour.

The institutional capacity of the state, narrowly defined, is the ability of a government to enforce laws and regulations. While there are a lot of subjective indices (corruption, rule of law, government effectiveness, etc.) that supposedly measure state institutional capacity, many researchers do not think they help to explain economic performance and consider them biased[3]. The natural objective measures of state institutional capacity are the murder rate – non-compliance with the state’s monopoly on violence[4], and the shadow economy – non compliance with the economic regulations. China is unique in having some of the lowest scores for both indicators in the developing world, comparable to those of developed countries (see chart 1).

Chart 1. Murder rate per 100,000 inhabitants and government effectiveness index (ranges from -2.5 to +2.5) in 2002

Upper chart - countries with a high (15-75) murder rate; Lower chart – countries with a low rate (0-3). Source: WHO, World Bank.

With less than 3 murders in 2002 per 100,000 inhabitants against 1-2 in Europe and Japan and over 5 in the US) China looks like a developed country. Only a few developing countries, mostly in the Middle East and North Africa (MENA), have such low murder rates, normally they are considerably higher, as in Latin America, Sub Saharan Africa, and many Former Soviet states. By way of comparison, it took Western Europe 300 years to move from a murder rate of over 40 per 100, 000 inhabitants in the sixteenth century to current levels of 1-2 murders per 100, 000 inhabitants in the nineteenth century beyond [5].

The same is true of the shadow economy: it is less than 17% of the Chinese GDP, lower than in Belgium, Portugal, Spain, whereas in developing countries it is typically around 40%, sometimes even over 60%. Only few developing countries have such low share of shadow economy, in particular, Vietnam and some MENA countries (Iran, Jordan, Saudi Arabia, Syria).

Chart 2. Share of the shadow economy in GDP in 2005, %, and government effectiveness index in 2002 .

Source: World Bank. Data on shadow economy are from: Friedrich Schneider. Shadow Economies and Corruption All Over the World: New Estimates for 145 Countries. – Economics. Open Access, Open Assessment E-Journal, No. 2007-9 July 24, 2007 (measures of the shadow economy are derived from divergence between output dynamics and electricity consumption, demand for real cash balances, etc.).

Where does the strength of the Chinese institutions come from?

The pre-conditions for the Chinese success of the last thirty years were created mostly in the preceding period 1949-76. It would be no exaggeration at all to claim that without the policies implemented by Mao’s regime, the market-type reforms of 1979 and beyond would never have produced the impressive results that they did. In this sense, economic liberalization in 1979 and beyond was only the icing on the cake. The other ingredients, most importantly strong institutions and human capital, had already been provided by the previous regime. Without these other ingredients, liberalization alone in different periods and in different countries was never successful and sometimes was counterproductive, as in sub-Saharan Africa in the 1980s.

Market-type reforms in China in 1979 and beyond brought about such an acceleration in economic growth because China already had an efficient government, created by the Chinese Communist Party after the Liberation, which the country had not had in centuries - not least because of its deliberate destruction by various colonial, European aggressors. Through the party cells in every village, the communist government in Beijing was able to enforce its rules and regulations throughout the country more efficiently than Qing Shi Huang Di or any subsequent emperor, not to mention the Kuomintang regime (1912-49). While, in the late nineteenth century, the central government had revenues equivalent to only 3 percent of GDP (against 12 percent in Japan right after the Meiji Restoration) and, under the Kuomintang government, they increased to only 5 percent of GDP, Mao’s government left the state coffers to Deng’s reform team with revenues equivalent to 20 percent of GDP [6].

The Chinese crime rate in the 1970s was among the lowest in the world, A Chinese shadow economy was virtually non-existent, and corruption was estimated by Transparency International even in 1985 to be the lowest in the developing world (China, together with the USSR, was in the middle of the list of 54 countries – below Western countries, but ahead of most developing countries and even ahead of South Korea, Greece, Italy, and Portugal [7]). In the same period, during “clearly the greatest experiment in the mass education in the history of the world”, literacy rates in China increased from 28 percent in 1949 to 65 percent by the end of the 1970s (41 percent in India, for comparison)[8].

By the end of the 1970s, China had virtually everything needed for growth except some liberalization of markets — a much easier ingredient to introduce than human capital or institutional capacity. The foundations for the truly exceptional success of the post-reform period had been laid purposefully in 1949-76. [9]

But even this seemingly simple task of economic liberalization required careful management. The USSR was in a similar position in the late 1980s. True, the Soviet system lost its economic and social dynamism, growth rates in the 1960s-80s were falling, life expectancy was not rising, and crime rates were slowly growing, but institutions were generally strong and human capital was large, which provided good starting conditions for reform. Nevertheless, economic liberalization in China (since 1979) and in the USSR and later in Russia (since 1989) produced markedly different outcomes.[10]

[Russia was assaulted for decades by the West and suffered massive human and material losses in the Second WW. China may have been having objectively hard and troubled times but it was not under attack in the same way, and having itself constantly diverted from its course of action by the Americans].

Fast economic growth can materialize only if several necessary conditions are met simultaneously. Specifically rapid growth requires: infrastructure, human capital, in agrarian countries even land re-distribution, strong state institutions, and economic stimuli, among other things. Rodrik, Hausmann, and Velasco talk about “binding constraints” that hold back economic growth; finding these constraints is a task in “growth diagnostics”[11]

Why did economic liberalization work in central Europe but not in sub-Saharan Africa and Latin America? The answer, according to the outlined approach, would be that in central Europe the missing ingredient was economic liberalization, whereas in Sub-Saharan Africa and Latin America there was a lack of state capacity, not a lack of market liberalization. Why did liberalization work in China and central Europe but did not work in the Commonwealth of Independent States? It is because in the CIS it was carried out in such a way as to undermine state capacity — the one useful heritage of the socialist past ― whereas in central Europe and even more so in China , state capacity did not decline substantially during transition?

Unlike Russia after 1991, so far it seems that China in 1979-2009 managed to preserve its strong state institutions better — the murder rate, a reliable measure of state capacity as noted above, in China is still below 3 per 100,000 inhabitants compared to about 30 in Russia in 2002 and about 20 in 2009. In the 1970s, under the Maoist regime, the murder rate in Shandong Province was even less than 1 [12], and in 1987 it was estimated to be 1.5 for the whole of China [13]. The threefold increase in the murder rate during the market reforms is comparable with the Russian increase, but Chinese levels are nowhere near the Russian levels.

If the Chinese model exists, is it replicable and sustainable, or even desirable?

The litmus test is a question on which economists sharply disagree: where will the next economic miracles occur, if at all.

Today, conventional wisdom suggests democratic countries that encourage individual freedoms and entrepreneurship, as Mexico and Brazil, Turkey and India, for future growth miracles, whereas rapidly-growing, currently authoritarian regimes, like China and Vietnam or Iran and Egypt, are thought to be doomed to experience a growth slowdown, if not a recession, in the near future. According to Jack Goldstone [14], “a country encouraging science and entrepreneurship will thrive regardless of inequality: hence India and Brazil, and perhaps Mexico, should become world leaders. But I say countries that retain hierarchical patronage systems and hostility to individualism and science-based entrepreneurship, will fall behind, such as Egypt and Iran ”. Many believe that rapid growth could be achieved under authoritarian regimes only at the catch-up stage, not at the innovative stage: once a country approaches the technological frontier and it becomes impossible to grow just by copying innovations of the others, it can continue to advance only with free entrepreneurship, guaranteed individual freedoms and a democratic political regime [15].

We still do not have enough evidence for innovation-based growth. For one thing, on all measures of patent activity, Japan , South Korea and China are already ahead or rapidly catching up with the US. The patent office of the United States of America, which had consistently issued the highest number of patents since 1998, was overtaken in 2007 by the patent office of Japan . The patent office of China replaced the European Patent Office as the fourth largest office in terms of issuing grants (the five largest patent offices - those of Japan, the USA, the Republic of Korea, China and the EPO accounted for 74.4% of total patent grants). The number of resident patent filings per $1 of GDP and $1 of R&D spending is already higher, sometimes considerably higher, in Japan, Korea and China than in the US [16].

And the evidence for catch-up growth is controversial to say the least. Imagine, for instance, that the debate about future economic miracles were happening in 1960: some would be betting on more free, democratic and entrepreneurial India and Latin America, whereas others would predict the success of authoritarian (even sometimes communist), centralized and heavy handed government interventionist East Asia. What is unknown, however, is whether the gradual weakening in the reform period capacity of the Chinese state will continue to weaken further, which will convert China into a “normal” developing country. In this case Chinese rapid growth would come to an end and there wouldn’t be any more a question of what is so special about the Chinese economic model.

POSTSCRIPT by DMN: The 27 May issue of the Russian magazine "Russkiy Reporter" lists Vladimir Popov among the "10 best [Russian] economists and sociologists in 2000-2010". Vladimir is sketched on the right-hand top corner of the magazine's cover.
Warmest congratulations, Vladimir!

[1] New Economic School, Moscow. vpopov@NES.RU,

[2] Anatole Kaletsky. “We need a new capitalism to take on China . If the West isn’t to slide into irrelevance, governments must be much more active in taking control of the economy”. “The Times”. February 4, 2010,

[3] Mushtaq H. Khan. Governance, Economic Growth and Development since the 1960s. DESA Working Paper No. 54, August 2007.

[4] Crimes are registered differently in different countries—higher crime rates in developed countries seem to be the result of a better registration of crimes. But serious crimes, like murders, appear to be registered quite accurately even in developing countries, so an international comparison of murder rates is well warranted.

[5] Eisner, Manuel. Long-Term Historical Trends in Violent Crime. – Crime and Justice, Vol. 30 (2003), pp 83-142.

[6] Lu, Aiguo. China and the Global Economy since 1840. New York , St. Martins Press, 1999.

[7] Internet Center for Corruption Research, Historical comparisons. Http://

[8] Peterson Glen. State Literacy Ideologies and the Transformation of Rural China. The Australian Journal of Chinese Affairs, No. 32 (Jul., 1994.

[9] To a lesser extent, this is true for India : market-type reforms in the 1990s produced good results because they were based on the previous achievements of the import substitution period. Fast Indian growth is sometimes attributed to the deregulation reforms of the 1990s, but it was shown that fast growth actually started in the early 1980s, well before the deregulation reforms were launched (Ghosh, Jayati. Macroeconomic and Growth Policies. Background Note. UN DESA, 2007). Like Chinese growth, Indian growth was based on the achievements of the 1950s-70s period of ISI and mobilization of domestic savings: the savings rate (as a percentage of GDP) doubled in the last fifty years, going up from 12-15% in the 1960s, to 16-20% in the 1970s, 15-23% in the 1980s, 23-25% in the 1990s, and to 24-35% in 2000-08.

[10] Popov, V. Shock Therapy versus Gradualism Reconsidered: Lessons from Transition Economies after 15 Years of Reforms. – Comparative Economic Studies, Vol. 49, Issue 1, March 2007, pp. 1-31
(; Popov, V. Why the West Became Rich before China and Why China Has Been Catching Up with the West since 1949: Another Explanation of the “Great Divergence” and “Great Convergence” Stories. -NES/CEFIR Working paper # 132, October 2009.

[11] Rodrik, Dani, R. Hausmann, A. Velasco. Growth Diagnostics. 2005. Http://

[12] Shandong Province database [ Shandong sheng shengqing ziliaoku]. PPP GDP per capita in the 1970s was about $1000 – at the same level as in Western Europe in the seventeenth century, when the murder rate was about 10 per 100, 000 inhabitants (Eisner, op.cit; Maddison, Angus. Statistics on World Population, GDP and Per Capita GDP, 1-2008 AD (

[13] WHO Health for All Database, 2004.

[14] Goldstone, J. Unpublished comments on Popov, V. Why the West Became Rich before China and Why China Has Been Catching Up with the West since 1949: Another Explanation of the “Great Divergence” and “Great Convergence” Stories. -NES/CEFIR Working paper # 132, October 2009.

[15] Ronald Inglehart and Christian Welzel. Modernization, Cultural Change, and Democracy: The Human Development Sequence. Cambridge University Press, 2005.

[16] World Intellectual Property Indicators. WIPO, Geneva , 2009.

Sunday, May 9, 2010

How to turn a minor crisis into a Greek tragedy

In the last four months the Greek economy has escalated from a minor national crisis to a near-catastrophe spreading to the whole of Europe, due to a combination of:

genuinely worrying Greek macroeconomic trends - in terms of government deficit, public and private debt and its maturity structure, trade competitiveness, current account imbalances - made worse by a recent and past record of national accounts falsification and cosmetic manipulations (both the responsibility of past right wing governments);

plus European chauvinism in wanting to keep the IMF out of it in spite of the fact that only the IMF Board can mobilise substantial resources more cheaply and quickly (in half an hour or so) and smoothly than anybody else, and Greece is actually entitled to those funds. The very proposal of setting up a European Monetary Fund was unnecessary (why have a regional agency when there is a global one, should we also have a European Trade Organisation, a European Health Organisation, a Bank for European Settlements?). It was also a waste of time or, worse, a costly dilatory tactic;

plus German populism in delaying and opposing EMU assistance against the interests of the German governent and public (German banks have at least €32bn exposure to a Greek default, higher than the current German cost of a rescue package over three years, of €22.2bn), just to please the North-Rhine Westphalia electors voting today; Angela Merkel deserves to be duly punished for that;

plus the EU'S unbelievable vagueness about the scale, form and terms of a bail-out: "the EU will provide as much as it will be needed if and when it will be needed" does not tell investors what they want to know: how much, whether they will be guarantees or loans, by the Union or bilaterally by member states, EU or EMU. And there is still uncertainty about the very legality of a bail-out, with the German constitutional court examining various appeals against the rescue package. Jean-Claude Trichet and Angela Merkel insisted on "no subsidy" on interest to be charged to Greece, thus effectively casting serious doubts about the effectiveness and success of their own package. The compromise 5% interest eventually charged on EU states' bilateral loans is higher than both the interest charged by the IMF (just over 3%) and the cost of borrowing by the German government;

plus the adverse effects of silly pronouncements by a number of EU high officials and economic commentators, i.e. talks of possible expulsion of Greece from the eurozone (for which there is no legal instrument), or voluntary withdrawal by Greece returning to the drachma (this would require its withdrawal from the EU, which is not in anybody's interest, and just imagine the level to which drachma interest rates would rise) or the introduction of a currency parallel with the euro; or German withdrawal from the Eurozone for the reverse of those reasons, or a two-euro zone, one Southern and weak and the other strong and Nordic ...

plus Greek failure to apply in good time for even the little finance they had secured in April (€45bn), allegedly not to signal distress, yet thus precipitating a much greater distress.

plus delays and quarrels leading to interest spreads over Bundes and to CDS prices rising to the point that Greece could no longer afford to access international financial markets, for at such high market rates Greek debt would have been unsustainable and demonstrably ended in default in the near future.

At that point the scale of the package required rose to €110bn (€80bn from EMU member states, €30 from the IMF) but, by the time this was granted, "markets" wanted even more.

And the burden of adjustment will fall on Greek public sector employees and on pensioners. Some of them benefited from large public deficits, for instance through the hiring by the previous rightwing government of thousands of their supporters, and through an earlier retirement age than most (including Germans). But they were not the main beneficiaries of rising public debt, or of rising inequality at large. When Romano Prodi squeezed Italians hard in order to meet the Maastricht conditions to join the euro, at least he made some symbolic gestures of taxing interest revenues and putting some extra tax on real estate. The people on whom the burden of Greek adjustment unfairly falls today have every reason to show their dissent on the streets of Athens - especially since the party now in opposition, responsible for the debacle, will not face up to their responsibilities. Popular protest, of course, objectively strengthens the expectation and the likelihood of default. In 1988 Ceaucescu implemented a brutal deflation in order to pay off all of Romania's foreign debt at a stroke, but fortunately Greece 2010 is not Romania 1988: creditors, bailers-out and the Greek government should recognise that there are limits to the political feasibility even of otherwise sound economic policies.

The coup de grace to Greece and perhaps to the euro was given by rating agencies unreasonably downgrading government bonds in the Eurozone even after the large scale rescue package had been approved. The "three sisters" should have been utterly discredited by their past failures in predicting performance, from Enron to Lehman Brothers, and by their past record of frequent conflicts of interest, yet they still mould and guide expectations, and are taken seriously even by the ECB (until Trichet fortunately decided to keep accepting Greek bonds as collateral regardless of their credit rating, and initiated a long-required re-assessment of the rating agencies' status. Nevertheless, talk of setting up a European (public?) "independent" rating agency is laughable, for nobody would take seriously its ratings of European bonds.

The attack on the euro must have been - at least partly - encouraged by the Americans and the British in order to deflect public attention away from their own economic and political troubles. Not necessarily through a conspiracy, as it has been suggested by some commentators, more by following a natural and self-serving inclination. In the end - during the night of Friday 7 May - Europe delivered, but delivered so much later than they should have that the tragedy is not over by any stretch of the imagination. And the deal made even the usually clownesque Berlusconi - compared to Trichet and Merkel and Sarkozy - look like a born statesman.