Monsieur Trichet Is In Denial

On 27 January in Davos at the World Economic Forum the European Central Bank President, Monsieur Jean-Claude Trichet, stated boldly that “the euro is not in crisis”. He must have felt duty-bound to say that in an attempt to reassure international financial markets, regardless of what he really thought. If he actually believed what he said, then Monsieur Trichet is in denial, which is a poor foundation both for a fruitful discussion of the current crisis of the euro and for progressing towards its solution.

Of course, if one looked exclusively at the current exchange rate between the dollar and the euro and its recent trend, one would get the false impression that there is no crisis. On 29 January the euro stood at $1.37, a higher rate than before the Greek debt crisis erupted in February 2010 ($1.33), and much higher than the $1.18 rate to which it plunged in early May 2010 (and even that was 1cent higher than the initial exchange rate of 1.17 with which the euro started life in 1999). The euro recovery, however, was due primarily to the US Fed injecting $600bn liquidity over 8 months, compared with the comparatively restrictive policies of the ECB, and to US economic prospects being poorer than anticipated. After peaking at $1.42 last November, the euro fell again under $1.30 repeatedly (even a fortnight ago) with contagion spreading from Greece first to Ireland, then to Portugal, then threatening Spain.

Beside the exchange rate increased volatility, and the downgrading of credit ratings, a tangible and accurate measurement of the sovereign debt crisis of the euro is given by each country’s interest rate differential with respect to German bonds (usually taking 10-year bonds), the current yield on existing stock determining the rate at which the countries can borrow to rollover old debt or incur new debt. The spread over the German Bunds (whose yield has also risen as a result of the crisis, for fear of German exposure to baling out possible defaulters) has risen on average and significantly widened across countries over time, especially since the Greek crisis, and is now at record levels, higher than last May. Usually a 2% differential is regarded as the danger level; today Spain is just over, Italy just under that level; Portugal has almost 4% differential, Ireland over 6%, Greece 8 and a half per cent.

At interest rates higher than national growth rates (whether in nominal or real terms, as long as both are measured in the same way) national debt must increase relatively to GDP; debt is unsustainable and default looms. Even on the funds provided by the EFSF (the European Financial Stabilisation Facility set up last May) Greece and Ireland pay 5.8%, a rate lower than their market rates but higher than sustainable and signalling European lack of confidence in these countries’ ability to repay. Rescheduling of Irish and Greek debt – with lengthening of maturities and inflicting a haircut on investors – is now on the cards.

It is true that a recent bond issue by the EFSF was five times over-suscribed, but this was mostly “spurred by Basel III capital rules” set by the BIS, according to which AAA-rated sovereign bonds like those of EFSF “have a risk-weighting of 0%, which means that investors effectively don’t need to hold capital against it”. And that rating involves the EFSF over-collateralising its bonds reducing its operational capacity, and even EFSF bonds are subject to risk (for instance from the downgrading of one of the participating countries, which would require further capitalisation, see Klaus Regling, Eurointelligence.com 27 January).

The ultimate source of euro vulnerability is its premature birth. The single currency was supposed to be the crowning of the economic integration process, after political and fiscal union, after the unification of labour and social policies and, come to think of it, after a common foreign policy and a common army (though these could wait). Instead of which the single currency has been used to promote the so-called finalité politique, i.e. that political union that should have been the pre-condition of the euro. This is like a person buying clothes that are too tight and do not fit in the hope that this might facilitate slimming, by forcing one to diet: it does not work for me, it did not work for Europe. The fiscal constraints imposed by the Maastricht Treaty and the Growth and Stability Pact, 3% public deficit and 60% public debt, have not been observed by too many countries for too long (including Germany and France, who were first to violate the 3% ceiling), to be treated as substitutes for a fiscal union. Thus the initial fall and convergence of interest rates that occurred after the introduction of the euro have been reversed. The global crisis has lowered tax revenues and raised public expenditures, not least for rescuing financial institutions. Europe has reacted too slowly and inadequately to the sovereign debt crisis over the last year; European leaders have spoken with dissonant voices, often making perverse announcements, whether from ineptitude or malice.

Can the euro crisis be solved, or at least be significantly alleviated, by the issue of a single European bond covered by a European guarantee, to replace a sizeable tranche of national debts? This we will consider in one of the next posts.

Dr Marchionne’s Vietnam War

[SEE POSTCRIPT/UPDATE, POSTED BELOW AS A COMMENT]

In 1968, at the height of the Tet offensive, I argued with US sociologist Edward Shils (1910-1995) at Cambridge about the uselessness, wickedness and immorality of the Vietnam war. Shils shut me up curtly by saying that the US were in Vietnam simply “because they can”, and there was nothing more to be said. And so they could, of course: the US had the troops, the military hardware, the financial resources to do it, and they could get away with it, wanting to get away with it (at the time). Which of course did not imply that the war was in the US' best interests, that it was justifiable, or that the US would win it in the end. Shils lived long enough to see the inglorious débacle of the US last exit by helicopter from the roof of the US Embassy in Saigon.

In 2010 FIAT's Sergio Marchionne adopted an antagonistic industrial relations strategy towards his employees, first at the Pomigliano d’Arco plant in Southern Italy and then at the Mirafiori plant in Turin. Either FIAT employees accepted greater internal flexibility, duration and intensity of work or FIAT would invest an alleged €20bn elsewhere, notably in Serbia and in Canada. At Pomigliano a workers' referendum endorsed the deal but the overwhelming majority of over 60% was judged insufficient by Marchionne. At the Turin Mirafiori plant on 29 December FIAT signed an agreementwith all unions (Fim, Uilm e Fimsic) except with the traditionally more militant FIOM metalworkers. Now a referendum has been called on 13-14 January, and FIOM has called a general strike for 28 January inviting not only metalworkers but all "social opposition forces" from students to movements opposing water privatisation.

Marchionne’s attitude is reminiscent of Shils’ views on the Vietnam War: FIAT is fighting the metalworkers’ Trade Union FIOM “because it can”. Globalisation has dramatically increased labour markets competition in the world: labour migrations and production de-localisation are the more spectacular forms of such intensified competition, but trade liberalisation is its most important quantitative manifestation. Even if existing factories stayed for ever where they are, new production would naturally follow the logic of global comparative advantage. This is what has reduced the average share of wages in GDP in advanced countries from 65% to 55% in 1980-2005 (IMF World Economic Outlook June 2007), a trend that has continued to date except for a small rise in wage shares in 2009 due to the temporary fall of profits in the recession. This is what allows FIAT to give such a blunt ultimatum to its workers: take it or leave it, don’t even think you can negotiate anything else.

The former communist leader Piero Fassino – now candidate as mayor of Turin, FIAT’s headquarters – has stated that were he a FIAT employee he would support the proposed deal and vote Yes in the coming referendum. Other Democratic Party politicians have dissented: Marchionne has already succeeded in splitting not only the Unions but also the main Opposition party. (See Antonio Lettieri, "La sinistra ai piedi di Marchionne", Il Manifesto, 8-01-2011).

One’s vote in such a referendum is not necessarily a reflection of one’s politics, but of family circumstances and wealth. Were I a FIAT employee, faced with the brutal alternative between unemployment and a worsening of my labour conditions I too might well vote Yes in the referendum. Which does not imply that the deal is in FIAT’s best interests, indeed that it is necessarily superior to other deals reachable after negotiation, or that its political/social implications are desirable, especially in the long run.

Some aspects of the proposed deal are very disquieting. The proposal has not been discussed beforehand, even within those Unions that have supported it. Such referendums, overriding union leadership, are unprecedented so that there are no set rules: at Pomigliano a yes vote of over 60% was regarded as insufficient for FIAT to go ahead with investment; at Mirafiori Marchionne demands only “over 51%”. An unintended consequence of existing Italian legislation involves FIOM members losing the right to union representation unless FIOM signs the deal. This could be rectified easily by either government decree or by an additional provision in the agreement with FIAT, before the referendum takes place, but neither Italy’s weak, absentee and corrupt government nor FIAT have taken the initiative, in spite of protestations by several unions and politicians and not just by FIOM. The threat of losing union representation poses additional and improper pressure on FIOM members. The deal marks the end of collective bargaining – which is, among other things, an integral part of the European Social Model – and marks the re-emergence of enterprise-level bargaining outside medium and small size firms. FIAT has had to leave the Confederation of Italian Industries in order to replace the standing collective contract, but metalworkers could also be moved to the new contract in other enterprises that followed FIAT’s example.

A major problem is that FIAT’s so-called “Fabbrica Italia” project does not really guarantee FIAT’s employees anything at all. The €20bn investment “envisaged” – with an unspecified time-horizon – exists only in the vaguest and most nebulous industrial plan not worth the paper on which it is not written. So far only €1,3bn have been “planned”, only another €700mn have been identified at the very outset.

The new contract would be signed with a New Company, a joint venture with Chrysler. As is always the case with multinational companies, including joint ventures, the distribution of profits between FIAT and Chrysler would depend on transfer prices of components between the two partners. The criteria for such distribution has not been remotely faced by the parties, or even raised by the Unions.

The greater flexibility, the acceleration and prolongation of worktime involved in the deal seem too minor to really impact FIAT’s global competitiveness but represents merely a net worsening of working conditions. They are 1) a shortening of 10 minutes per day in work pauses (three 10’ pauses instead of two 15’ and one 10’ pauses) compensated by €0.1877 per worked hour or roughly €45 per month; 2) the postponement of the 30 minutes meal break to the end of the shift; 3) loss of illness allowance for period of “anomalous absenteeism” to be assessed case by case by a joint committee; 4) up to 18 8-hour shifts over six working days; 5) up to 120 hours overtime work without having to negotiate with the Unions, plus another 80 hours with union agreement; 6) in case of strikes or other breaches of contract FIAT would not be liable to honour union permits and payments.

Would such greater internal flexibility, prolongation and intensification of work solve FIAT’s problems and miraculously restore competitiveness in a sector affected by world-wide supply over-capacity and demand recession? (see a letter endorsed by 146 Italian economists on the subject, on the Sbilanciamoci website. )

Fact 1. In 2009 FIAT produced 650 thousand cars in Italy, barely a third of those produced in 1990, compared to a planned 2mn and to the stability and growth of quantities produced in the major European countries. The stated intention of more than doubling output seems over-optimistic.

Fact 2. FIAT spends on productive investments, and on Research & Development, shares of turnover significantly lower than those of its main European competitors, and it is not active in the development of low environmental impact alternatives. European competitors of FIAT, like Volkswagen, have responded to crisis by reducing working hours while protecting wages and employment.

Fact 3. While in 2004-2008 FIAT recovered from a very serious crisis and developed a few models, in the last two years FIAT has not introduced any new models; its market share in Europe has fallen to 6.7%, the largest drop in car output shares in Europe in 2010.

Fact 4. In 2010 Fiat shares rose 90%, beating all competitors, also following the recent split of Fiat Industrial from the rest of the company involved in car production. In the third quarter of 2010 FIAT was first in the Italian stock exchange in terms of shareholder value, with a 33% return on capital.

Fact 5. In spite of the rhetoric of FIAT depicted as an enterprise “capable to walk in the market on its own legs”, from the end of the 1980s and the early 2000s FIAT has enjoyed public subsidies of the order of €500mn per year. Perhaps FIAT should have been given subsidies to deal with the crisis by the Italian government, or at least Marchionne should have asked.

Fact 6. Over the last ten years FIAT global employment in car production has fallen from 74 thousand to 54 thousand units, of which only 22,000 are in Italian factories. Employees have average skill levels lower than those of FIAT’s competitors, and among the lowest wages in the sector in Europe.

Fact 7. In 2004-2009 Dr Marchionne earned €36.6mn euro, including the accumulation of his golden handshake, i.e. €6.3mn a year. Plus 4million free shares, worth 69.8mn on 7 January 2011, which will have appreciated further already since then. This brings his yearly income to €38.8 mn a year (See Massimo Mucchetti, "Marchionne e lo stipendio del dipendente FIAT", Corriere della Sera, 9 January 2011), which corresponds to 1,037 times the average yearly cost of Italian metalworkers' labour over the same period. Not that this matters for the plausibility of FIAT’s industrial policy stance but certainly not an irrelevant consideration in providing a perspective for the average FIAT metalworker, whether or not she is a FIOM member.

[SEE POSTCRIPT/UPDATE POSTED BELOW AS A COMMENT]

A Very Happy (Digital) Christmas

A Very Happy Christmas to all readers.




Normal Blogging will resume in the New Year.

Global Policy Forum, Yaroslavl 8-10 September

Global economic integration, as measured by the ratio between world exports and world GDP, regressed slightly in 2009 only to resume its course immediately at an even faster rate. Globalisation, however, has not been matched at all - for better or worse - by the progress of global governance institutions. This is why the feeble and fragmented powers of international economic institutions - over 2,000 of them - are accompanied only by ad hoc arrangements from G-n groupings (from the G-1, i.e. the USA, to the G-24 of most advanced countries or the recently emerging G-20 including large less developed actors) to various Global Forums with the participation of some world politicians, businessmen and intellectuals. The Davos World Economic Forum was first and remains the foremost, but others have arisen in equally desirable locations. The millenary town of Yaroslavl - an ancient, former temporary capital of Russia - is hosting its second Global Policy Forum on 8-10 September, with prospective participants including the Russian President Dmitry Medvedev, the Spanish Premier José Luis Rodriguez Zapatero and the French Premier Francois Fillon. it is devoted to the general theme “The Modern State: Standards of Democracy and Criteria of Efficiency”.

Having accepted an invitation to join the Yaroslavl Forum, I was asked by the editor of the Conference website http://en.gpf-yaroslavl.ru/, Dr Dmitry Uzlaner, a number of interesting questions, listed below with my answers.

You are going to take part in the section 'The State as an Instrument of Technological Modernization'. What are your expectations about it? What problems seem to you most topical in this context?

Technological modernisation should not be understood as the introduction, at the fastest rate and on the largest possible scale, of the latest technique available, or the most productive in a physical sense. Modernisation is desirable only if

1) it introduces the best-practice technique, i.e. that which minimises total production costs calculated at the competitive market prices of all inputs, and

2) on the scale determined by total costs not exceeding the operating costs of production on already existing plant, whose historical capital cost is sunk and therefore irrelevant.

When input prices change, or some costs formerly neglected are included in production accounting, the best-practice technique also may change. The technique that is best for oil at $10 a barrel is not the same for oil at $150. The technique that is best when producers do not pay for the pollution generated in the production or consumption of their products is not that which is best when they do pay for it. A significant rise in the price of oil, or taking into account pollution costs previously unaccounted for, can require not only a technological change but possibly a “regression” to older and/or less productive techniques. This problem is well understood by economists and businessmen, but is all too often neglected by politicians and the general public.

The role of the State is paramount in: funding fundamental research and general technical education; enforcing market competition (for imperfect competition will distort the incentives to modernize and adversely affect the scale though not necessarily the occurrence of modernization; generally creating an economic environment favourable to modernization, for instance striking a balance between the production of new technology via patents protection, and the diffusion of technology. But there is no case for the State to have a direct hand in the choice of particular techniques in particular sectors let alone enterprises.

Which economic systems are doing better in the modern world? What factors determine success and failure of the system?

The collapse of the Soviet-type system in 1990-91 has led to a widespread conviction of the superiority of the capitalist system: the combination of market efficiency and the private appropriation of efficiency gains is a major stimulus to technical progress and innovation. For instance, Janos Kornai (Innovation and Dynamism, WIDER Working Paper No. 2010/33) argues that capitalism provides a strong incentive to dynamism, enterprise and the innovation process, and that every revolutionary new product for civilian use - such as information technology, the computer, the mobile phone and internet - has been brought about by the capitalist system. However, we should take into account the role of state-initiated and state-funded research, in this case space research, and its impact on such technical developments. It is true that Silicon Valley could not have developed in a centrally planned economy, but what seems indispensable is not necessarily a capitalist system, but a competitive market environment. Managers of private enterprises are already more motivated by profits than their shareholders, and equivalent incentives can be replicated in state-owned enterprises. China today, for instance, displays more dynamism, enterprise and innovation - and more resilience to economic crisis - than the traditional capitalist system, though this has far reaching implications for democracy.

Today Russia strives for the creation of modern high-tech infrastructure and technological renovation of the entire production sector. What to your mind are the best development strategies for countries like Russia? Which post-communist states were most successful in economic and political modernization? What factors determined their success?

In its current situation Russia, having suffered from decades of central planning inefficiencies, cannot go wrong by upgrading infrastructure and production; the question really is at which point such policy should be subjected to a strict analysis of economic efficiency. Russia has been blessed by an abundance of natural resources, notably oil and gas, which is an opportunity to be exploited. But the development of a diversified industrial basis is essential in the medium-to-long run.

Among post-communist states, economic success has not always gone hand in hand with democratic progress (from Poland to Belarus and to some extent Russia itself), but democracy must be regarded as a necessary pre-condition of long-term sustainable economic development.

What trends in modern economic theory you find most interesting and percective?

The global financial crisis of 2007-2010 has led to a considerable re-assessment and down-grading of the hyper-liberal economic theories of the 1990s and most of the 2000s. Markets are often non-competitive; in any case they are incomplete, given the lack of inter-temporal and contingent markets, leading agents to act on the basis not only of current prices and quantities of today’s goods, but also of their expectations of future prices and quantities. This is why higher savings might lead to a depression, and a global lowering of wages might increase unemployment. We live in a Keynesian world. Not only are markets somewhat inefficient and unstable, they are also patently unfair as demonstrated by rising national and global inequality.

Having said that, we must recognize that markets - with strong qualifications for at least some financial markets like derivatives - are absolutely indispensable in any economic system, for they provide automatic mechanisms of economic adjustment: of enterprise production to prices, of prices to excess or deficit demand, of actual to desired capital through capital stock adjustment via investment, of inputs supplies to actual outputs. We cannot live without markets.

What, to your mind, are the main problems of interaction between the intellectual community and policy makers? What form of communication is urgently needed? Is it just financing of intellectual think-tanks by some governmental bodies, or a kind of intellectual intercourse like forums in Davos, St. Petersburg, or Yaroslavl, etc.?

The decisions taken by policy-makers reflect mostly their own interests and values and those of their clients, and are rarely purely technical decisions that might be influenced by arguments developed by the intellectual community which, moreover, itself might not be representative of the people. Therefore problems of communication and interaction arise only in the narrow range of decisions open to a technical/intellectual argument; such is the natural limited area of operation of both think-tanks and forums. The real problem is that of democratic formulation and implementation of the public interest, and in a global dimension - though think-tanks and forums such as that of Yaroslavl can indeed have positive effects.

Vladimir Popov replies on China

[A Guest Post by Vladimir Popov, New Economic School, Moscow, vpopov@NES.RU, http://www.nes.ru/~vpopov]

I am very grateful to everyone who commented on my post of 24 May on the Uniqueness of Chinese Capitalism. Here are some brief replies that I hope might promote further debate.

Mario stresses the prohibition of trades unions and strikes in today’s China. Well, trade unions formally exist, but the right to strike is really not guaranteed by Deng’s constitution, although it was guaranteed by Mao’s constitution. (By the way, the relative popularity of Mao and Deng in China today could be measured by observing the numbers at the memorial site where people can go and put virtual flowers to personalities they like: http://jidian.china.com Since 2009 and until July 8, 2010, Mao got over 2 million bouquets of flowers, Deng – only 33,000, less than Zhou Enlai (nearly 200,000) and Norman Bethume, a Canadian doctor helping Republicans in Spain in 1936-39 and Communists in China during the Anti-Japanese and Civil Wars (over 37,000)).

Mario questions my statement that all developed countries had authoritarian regimes in the past. “Including England, Sweden, Denmark, Switzerland, the United States? If you said "many developed countries had before" nobody could argue, but all? You might say more about this presumably universal authoritarianism”. Well, I would stick to what I said – there was life before democracy, which emerged at a very late stage of human history. In ancient Greece neither women nor slaves had voting rights. In France in 1815-30 voters amounted to only 0.25-0.3 per cent of the population, and about 0.6 per cent in 1830-48. In England suffrage was extended by the Reform Act of 1832. Nevertheless, voting rights were received by 14-18 per cent of men only. Universal male suffrage was introduced only in 1928. In Germany, Italy, Belgium women were not given voting rights until after the Second World War. Rich countries were generally late in introduction of universal suffrage: it was granted in 1965 in the USA, in 1970 - in Canada, in 1971 - in Switzerland. (Polterovich, Popov, 2007).

Mario writes: “Mao's contribution to filling state coffers is fine, but did he really contribute to building state institutions? I thought Maoism had been fairly destructive rather than constructive in this respect?”

I referred to the fact that Mao created the “vertical of power” that not only Putin, but Qin Shihuangdi (the first emperor that unified China in 3rd century B.C.) could not have dreamt of. I gave the data on shadow economy and murders. I said that party cells were created in every village, so for the first time in China’s history the central government in Beijing could enforce decisions taken in the capital all across the country. And I explained that government for the first time in Chinese history started to collect reasonable revenues (always a problem in developing countries).

A couple of examples can be enlightening. In Mao’s days policemen used to be unarmed like most British Bobbies. Bank officials collected cash from retail shops at the end of the business day and carried it back to the bank on a bike or via public transport (and unarmed, of course). Today, the same procedure is different – armoured vehicles, bullet proof jackets, helmets, machine guns…

Another good indicator of the ability to maintain social order and the magnitude of non-compliance with existing regulations is the incarceration rate – the number of inmates per capita. It is 120 per 100,000 against 751 people in prison or jail for every 100,000 population in the US and 151 in the UK. Which is the “land of freedom” and which is the “prison state”?

Anonymous comments that the lower Chinese murder rate does not account for “capital punishment and the silent massacre of female babies along with the number of suicides directly or indirectly induced by Chinese state repression and rule of force”. It does account for capital punishment; Amnesty International estimates that “Legal murders” – executions (1000-2000 a year) account for about 5% of total murders.

“The silent massacre of female babies” is probably a reference to Berlusconi statement that “under Mao's China they didn't eat babies, but they boiled them to fertilise the fields” (Berlusconi, 2006). There is a debate, whether China has sex-selective abortions (although it is illegal for doctors in China to reveal the gender of the foetus) because China has one of the highest gender imbalances for the newborns. But “silent massacre of female babies” is as probable as “boiling them to fertilize the fields”.

And on “suicides directly or indirectly induced by Chinese state repression and rule of force”: the total number of suicides in China is 21 per 100,000, quite high by international standards, but less than in Japan and Finland, and way less than in Estonia and Hungary.

Alberto’s comment that “authoritarian types of mixed capitalist economy with an important steering role for the state have thrived in South-East Asia, from Japan to Singapore, to South Korea and Taiwan, without any communist connotations, leading those countries to development and prosperity” is missing the point. All the countries mentioned were supported by the US during the Cold War as counterweights to global communism, some even call this “development by invitation”. Not only did they receive Western assistance, but also, and most important, got access to US markets. In addition in Japan and Korea the agricultural reform was carried by the US occupation authorities and in Taiwan it took place under pressure from the US.

In a sense, Alberto writes, “over the long haul Chiang Kai-shek has triumphed over Mao. (An analogous consideration could be made with respect to Vietnam, where after a long bloody civil war the vanquished appear to have triumphed over the victors.)”. I would dispute that. Chiang Kai-shek, as the puppet South Vietnamese government, had the time to carry reforms and produce an economic miracle but failed to do so. There was no growth and no peace in China in 1928-48, when Chiang Kai-shek was the leader. When Chiang Kai-shek fled to Taiwan (even after the so called “golden decade of the 1930s”), he left China with GDP per capita of $500 (Maddison, 2008), same as in 1500, and a life expectancy of 35 years.

To put it differently, to produce an economic miracle in Taiwan Chang Kai-shek had to be defeated and learn from his defeat and from the communists (and to carry out agrarian reform on the island that he never carried out in China) and to get a support from the US (access to the US market).

“…Maoism left the Chinese economy and society in such a bad shape that simply the demolition of Maoism produced the economic miracle”, says Alberto. This is wrong again. The catch-up development of China since 1949 was extremely impressive: not only were growth rates in China higher than elsewhere after the reforms (1979 onward), but even before the reforms (1949-79), despite temporary declines during the Great Leap Forward and the Cultural Revolution, Chinese development was quite successful. According to Maddison (2008), Chinese per-capita GDP was about 70 percent of India’s in 1950, rose to about 100 percent by 1958-59, fell during the Great Leap Forward, rose again to 100 percent of the Indian level by 1966, fell during the first years of the Cultural Revolution, and rose again to 100 percent by 1978. By 2006, it was more than twice the Indian per capita GDP. World Bank estimates, however, suggest that since 1960, Chinese growth rates (five-year moving averages) were always higher than Indian growth rates. Life expectancy in China in 1950 was only 35 years but by the end of the 1970s rose to 65 years—thirteen years higher than in India. Today, it is seventy-three years—seven years higher than in Russia and India. Some charts below (from Popov, 2009).

Berlusconi (2006). Communists boiled babies: Berlusconi. “Herald Sun”, 27 March 2006
http://www.freerepublic.com/focus/f-news/1603618/posts

Maddison, A. (2008). Statistics on World Population, GDP and Per Capita GDP, 1-2006 AD (http://www.ggdc.net/maddison/Historical_Statistics/horizontal-file_09-2008.xls)

Polterovich, V. Popov, V (2007). Democratization, Quality of Institutions and Economic Growth.
-TIGER Working paper No. 102, Warsaw, July 2007.

Popov, V. (2009). 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.

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, http://www.nes.ru/~vpopov.

[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, http://www.timesonline.co.uk/tol/comment/columnists/anatole_kaletsky/article7014090.ece.

[3] Mushtaq H. Khan. Governance, Economic Growth and Development since the 1960s. DESA Working Paper No. 54, August 2007.
http://www.un.org/esa/desa/papers/2007/wp54_2007.pdf

[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://www.icgg.org/corruption.cpi_olderindices_historical.html

[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
(http://www.nes.ru/~vpopov/documents/Shock%20vs%20grad%20reconsidered%20-15%20years%20after%20-article.pdf); 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://ksghome.harvard.edu/~drodrik/barcelonafinalmarch2005.pdf

[12] Shandong Province database [ Shandong sheng shengqing ziliaoku].
http://www.infobase.gov.cn/bin/mse.exe?seachword=&K=a&A=16&rec=42&run=13.%20%20Chinese%20PPP%20GDP%20per%20capita%20in%20the%201970s%20was%20about%201000Chinese 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 (http://www.ggdc.net/maddison/).

[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.

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.