Economic Theory and Economic Reform in China: Neo-Classical Economics vs. Neo-Socialist Economics?

Justin Yifu Lin discusses his policy recommendations

Richard Gunde

What should the government of China do to guide China’s economic system during this period of transition? In particular, what should be done with China’s state-owned enterprises (SOEs)? In a talk at UCLA on March 31 on this fundamental question, Justin Yifu Lin, one of China’s most prominent economists, spoke on the applicability—or, more precisely, the inapplicability—of neo-classical economics to drawing up realistic policy recommendations.

In a talk entitled “Viability, Economic Transition, & Reflections on Neo-classical Economics,” Professor Lin, the founder and director of the China Center for Economic Research at Peking University (for a biographical sketch, go to the bottom of this article), focused on the issue of viability. An implicit assumption in neo-classical economics is that “in an open, competitive market, a firm is expected to earn a socially acceptable profit without any external subsidy or protection, if the firm has a normal management.” Firms that are not profitable – in other words, firms that are not viable – will (and according to neo-classical theory, should) fail. This assumption, Lin maintained, may be suitable for market economies but it may not be for transition economies.

Shock Therapy vs. Piecemeal Reform

Following the assumptions of neo-classical economics, the more or less stringent shock therapy applied to the former Soviet Union and the countries of Eastern Europe – where government subsidies were quickly and ruthlessly cut or entirely terminated, prices were liberalized, and firms were privatized – should have resulted in overall economic growth. Similarly, in China the piecemeal approach of continuation of subsidies to various SOEs while permitting non-state firms to enter the market should have led to stagnation, or worse. In fact, the economy of the former Soviet Union did not do well, while the economy of China has prospered. For example, in 1995 Russia’s GDP was only about half of what it had been in 1990. In comparison, from 1990 to 2001, China’s GDP grew at an annual rate of 10 percent while its foreign trade increase at around 15.2 percent per year.

The rigorous transition policies advocated by the World Bank and the IMF, noted economics at Harvard and MIT, and others following neo-classical theory thus failed in Russia and elsewhere in the former Soviet Union. The reason for this failure, according to Lin, is because with the viability assumption, attention was concentrated on such issues as property rights, corporate governance, government intervention, and others related to the firm’s management. However, Lin argued, many of these issues are in fact endogenous to the problem of firm viability. If policies do not address the real issues that affect firm viability, those policies are bound to fail.

Comparative Advantage & State Planning

In transition economies and many developing countries, enterprises are often unprofitable, even with normal, effective management. The reason has to do with comparative advantage: If the firm’s choices of what it will produce (its products) and how it will produce (its choices of technology) are not consistent with the comparative advantage determined by the factor endowment structure of the economy, the firm will not be profitable. (Factor endowment refers to capital, labor, and natural resources.)

In a transition economy, the state may have reasons for wanting enterprises to ignore comparative advantage. For instance, for national security, the state may feel it is essential to have capital-intensive enterprises that produce high-tech weapons, even if such firms are not profitable. Obviously, for such firms to survive, they will be government support. This support can take several forms:

• direct subsidies
• trade barriers (to prevent independent firms from entering the field and competing) and monopolies, both of which can assist the firm in raising prices to a point where it becomes viable
• other mechanisms, such as suppressing interest rates, holding down wage rates, controlling distribution of raw materials, and so on

Such steps will introduce distortions. Thus, a plan is needed to allocate resources to industries and sectors to which the state assigns high priority.

The Prevalence of the Viability Problem

The problem of viability is not only key in transitional economies, it is also widespread in developing economies. In an effort to catch up with developed countries, developing countries create many non-viable firms. Economic performance is poor and crisis is frequent. The conditions that the IMF imposes in order for countries to qualify for help often create great difficulties in those countries.

Realistically speaking, the issue of viability in such countries needs to be addressed; one cannot simply recommend that all non-viable firms be allowed to go bankrupt. The goal of economic policy in such countries should be to upgrade the factor endowment structure. Since the endowment of land and other natural resources in any country is fixed, the upgrading of the endowment structure means an increase in capital. Capital comes from the accumulation of economic surplus. To create the maximum economic surplus, a country must put into play its comparative advantage. In many cases, this will be facilitated by cooperation among firms and industries, and here again, there is an important planning role for the government to play.

The Viability Problem & the Failure of SOE Reforms in China, Social Burdens, and Policy Burdens

Many of the attempted or proposed reforms of China SOEs engendered – or are likely to engender – very difficult problems. For instance, the attempt to create managerial autonomy (through, for instance, allow SOE enterprises to retain their profit and/or enter into sales or purchase contracts with other firms) lead to the problem of a clash between improving productivity and declining profitability. Another solution that has been tried is property rights reform, in other words creating a modern corporate system with firms that sell stock. The problem with this is that it has led to asset stripping and speculation and manipulation in the stock market.

Others reforms have shifted social burdens from the state to the SOEs. For instance, before the reform era, there was no such thing as redundant workers, since the state mandated jobs for all workers, and provided the salaries. The same was true of old-age pensions. But with the reforms, many workers have been made redundant (that is, they have been laid off or fired), imposing on many SOEs the burden of paying severance packages. Also firms are now responsible for bearing the cost of pensions.

The main existing problems of Chinese SOEs involve China’s weak banking system (anywhere from 25 percent to 45 percent of loans are nonperforming), corruption, and regional disparities. The poor performance of SOEs lies at the heart of these problems. Therefore, obviously the key to solving these problems is solving the problem of the SOEs.

Unless the government is willing to let all non-viable SOEs go bankrupt, some government action to provide support is essential. This should involve, among other things, a reduction in redundant workers (through, most importantly, economic growth and the creation of new jobs) and the creation of a government-sponsored social security system.

But the question is: Does the government have enough resources to accomplish this? Lin’s answer is yes. Implementing these reforms, which will lead to higher efficiency and greater economic growth, may ultimately cost no more than continuing the present system.

Policy Recommendations

Professor Lin’s main recommendations for solving the problem of China’s SOEs are:

• If a firm’s output is needed for national security, or is otherwise according high priority by the government, then the government should support such a firm.
• SOEs with a big domestic market should be free to attract international capital.
• SOEs without a big domestic market should be free to change their product mix to suit the market. Many such firms have excellent engineers and, if given enough leeway, should be able to produce products that will succeed in the market.
• If SOEs have no comparative advantage, they should be allowed to go bankrupt. In Lin’s view, this will be a relatively small number of firms.

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Justin Yifun Lin (Ph.D., University of Chicago, 1986) is the founder and director of the China Center for Economic Research at Peking University www.ccer.pku.edu.cn/ and professor of economics at Hong Kong University of Science and Technology. The China Center for Economic Research is the first and only think tank on economic policy in China that is completely staffed with scholars educated outside of China. Professor Lin was a Visiting Professor in the Department of Economics and Center for Chinese Studies, UCLA, 1989-1993.
Professor Lin is the author of eight books, including the China Miracle: Development Strategy and Economic Reform, which has been published in seven languages, and the State-owned Enterprise Reform, which is available in Chinese, Japanese, and English. He has published more than 100 articles in refereed international journals and collected volumes on history, development, and transition. Among many of his public roles in China, Justin Yifu Lin was a senior advisor to the Drafting Committee of China's Tenth Five-year Plan, an advisor to the mayors of Beijing, Shanghai and Tianjin, and a member of the National Committee, China People's Political Consultation Conference. He also serves on several international committees, leading groups, and councils on development policy, technology, and environment. He was awarded the 1993 and 2001 Sun Yefang Prize (the highest honor for economist in China), the 1993 Policy Article Prize of Center for International Food and Agricultural Policy at University of Minnesota, the 1997 Sir John Crawford Award of the Australian Agricultural and Resource Economics Society, the 1999 Best Article Prize of the Australian Journal of Agricultural and Resource Economics, and various other prizes.
A number of his working papers and journal articles may be found at the EconPapers website.

Published: Wednesday, April 02, 2003