China's economic conditions

China's economic history

China's communist economy

China's economic liberalization

Economic conditions in China:

&

  This is a textbook. In about 400 pages, it analyzes history and applies traditional economic analysis and mathematical econometrics in analyzing and explaining the Chinese economy. There are in fact many pages of econometric analysis.
 &
  However, Chow does an excellent job explaining everything in plain English - in a manner easily understandable by any intelligent non economist - so the econometric segments can be skipped over without loss. The first 86 pages of plain text explanations of historic background and current status are worth the price of the book.
 &
  In short, this is a fine - perhaps essential - source of information about China. This is the book to read if you want to understand modern China.

  For the general public, the author subsequently provided a shorter and less technical work. See, Chow, "Knowing China."

  On the other hand, this is an excellent - perhaps essential - text for any course on modern China.
 &

Chow successfully provides "a clear picture of the dynamic and continuing process of transformation from a planned economy to a market economy."

Government economic planning was recognized as a disaster, and there was widespread disgust among the people and also within the government.

Commitment and skill at the top, ample human capital among the Chinese people, and the exuberant popular response to economic freedom are factors that Chow believes assure continued rapid economic growth, albeit at a somewhat declining rate.

  Chow sets out to describe "the process of economic transformation in China in its various aspects." He begins with the historical-institutional background as a basis for subsequent economic analysis. In this way, he successfully provides "a clear picture of the dynamic and continuing process of transformation from a planned economy to a market economy."
 &
  China's economic transformation was initially - necessarily - a top-down process because of the autocratic nature of its government. However, the process was shaped by Chinese historical and cultural factors, and was quickly influenced by grass roots initiatives as the Chinese people responded creatively and productively to their new opportunities.
 &
  The driving force for reform in China was the same as in Russia a decade later. Government economic planning was recognized as a disaster, and there was widespread disgust among the people and also within the government. 

  Leadership that cares about the economic condition of the people is the most basic precondition for economic development.

  As an autocratic socialist political system, China lacked the economic institutions and governance systems essential for functioning market systems. There was no pertinent political know how. There was no recent history of trial and error with policies designed to facilitate market commerce.
 &
  However, unlike Russia, there remained considerable private managerial capital in China. The commune system, for example, had been in place only 20 years. Unlike Russia, where communes existed for 60 years, there were still in China farmers who remembered private agricultural methods. Initial reforms in agriculture were thus an immediate success. "The success of agricultural reform in China provided the economic foundation for reform in other sectors."

  Of course, the proper comparisons for Chinese transformation efforts are thus not with Russia, but with Poland and the other Eastern European states.

  The political process was soon guided and driven by pragmatic market forces loosed by economic liberalization. Grass roots private and village and township enterprises quickly took on institutional lives of their own. Commitment and skill at the top, ample human capital among the Chinese people, and the exuberant popular response to economic freedom are factors that Chow believes assure continued rapid economic growth, albeit at a somewhat declining rate.
 &

Economic wealth has spread, giving the Chinese people "much more political power than before." Foreign trade and investment have opened contacts with the outside world. Modern concepts of law and democracy are becoming increasingly familiar. Significant legal reforms have been initiated.

  Chinese historical and cultural traditions heavily impact the transformation process. Social networking - "guanxi" - permeates commercial arrangements. Bureaucratic traditions - both predating and since Communist rule - still powerfully influence government officials, state owned enterprises ("SOEs"), and banking and financial systems, and even private enterprises. Political and cultural constraints remain powerful under a political system that remains autocratic.
 &
  Thus, much of the transformation process is understandable only with reference to unique historical, institutional and political factors - and only with reference to the personal characteristics of Chinese political leaders like Deng Xiaoping. Understanding Chinese economic transformation requires consideration of the complex interactions of governmental and non governmental influences, and the nature of Chinese society and its bureaucratic methods.
 &
  Two decades of economic reform has in fact led to significantly more openness and freedom. Economic freedom has undeniably expanded. Economic wealth has spread, giving the Chinese people "much more political power than before." Foreign trade and investment have opened contacts with the outside world. Modern concepts of law and democracy are becoming increasingly familiar. Significant legal reforms have been initiated.
 &
  Politically, "[t]ruly democratic public elections" are held at the street district and village level - but not for county or higher officials. Lower level officials elect members to the Peoples Congress, which has been increasing its independence and power. Its members are increasingly educated and independent. They increasingly vote according to their own judgment on legislation and when electing officials to the highest levels of the government. Elections within the Communist Party are now sufficiently independent to prevent power being simply grabbed by a putative despot.

  "This is a sign of stability and resilience of the political leadership at the top."

There is an earnest desire within the Party to improve conditions and strengthen China.

  China skeptics have been proven wrong on many fronts, Chow notes. Leadership power struggles have been suitably contained within the Party's political system. Hong Kong has been largely permitted to continue under its separate system. Recent economic crises in Asia have not forced a devaluation of the Chinese yuan.
 &
  "By and large, the Chinese people are happy; and they are happy with their government." They have access to outside information flows from Hong Kong and Taiwan and other outside TV stations, and from fax and internet connections. It is now difficult for the government to manipulate information.
 &
  Of course, Party leaders are still determined to retain political power. However, beyond that - and inevitable levels of corruption - there is an earnest desire to improve conditions and strengthen China.
 &

  The Chinese people are hard working and entrepreneurial. (Indeed, like expatriates from India, Chinese have prospered everywhere but in their native land.) The Chinese bureaucracy in various ways both supports and hinders transformation. Traditional business practices that are heavily dependent on family and social contacts hinder foreign investment and the needed modernization of the legal system. Traditions still favor socialistic collective values over individual freedom. As a result both of humiliations in their recent history and pride in their longer history, nationalism is strong.

  During the 20th century, the competition between rival economic systems - often terribly bloody - was between capitalism and various forms of government directed economic systems. Socialist ideology played a major role in the hopeless sufferings of billions of peoples over several generations. In the 21st century, FUTURECASTS expects the competition to be between autocratic capitalism and democratic capitalism - hopefully without so much bloodshed - and with higher levels of prosperity possible under both systems.
 &
  Both systems have their strengths and weaknesses. Put simply, democratic systems are prone to demagogic raids on the treasury by politicians seeking to buy reelection with public funds. Autocratic systems are prone to largely unfettered corruption. The explosion of spending by state and local governments in the last half of the 1990s, and currently by Congress under cover of the War on Terrorism, are typical examples of political irresponsibility at the expense of the public interest.
 &
  However, if they remain politically stable, democratic systems are self correcting since policies that cause serious economic reversals also - albeit imperfectly and belatedly - cause political shifts in favor of economic rectitude. Autocratic and single party systems have no such self corrective mechanism.

  Indeed, Chow affirms that: "Power corrupts, and absolute power corrupts absolutely."

Reasons for skepticism:

Neither the debt nor the equity sides of the financing mechanism are functioning well enough to provide the financing needed for widespread reorganization. The major banks are mired in politically directed non performing loans that continue to increase - corporate governance does not inspire confidence in equities - and the government's finances are increasingly burdened with deficits and formal and informal guarantees.

Boosting - or even maintaining - agricultural incomes without moving most of China's many hundreds of millions of farmers off the land so farm size can be increased is simply not possible since there are no alternative sources of employment available for them.

  A skeptical view of the Chinese situation at this time is presented by The Economist. In "A Survey of China," 6/15/02, the survey acknowledges that matters are going well in China's eastern provinces and major cities, but sees considerable trouble elsewhere.
 &
  Village and township elections are not held everywhere. These lowest level leaders in any event are practically powerless factotums, dominated by the Communist Party secretaries at their level. The elections that do take place are frequently heavily influenced by the Party.
 &
  According to the survey, the easy steps to rapid growth - simply removing the smothering hand of central planning and loosing the incentives of profit driven market directed commerce - have already been taken. To sustain economic growth fast enough to absorb China's vast masses of unemployed and underemployed and bear the financial and regulatory burdens of a bloated, corrupt, unaccountable bureaucracy, China must now establish the complex array of good governance institutions and policies and construct badly needed infrastructure.

  As FUTURECASTS has pointed out, China is still far from having a stable economic system, and the continuation of suitable reforms is crucial. However, as Chow correctly points out, perfection is not required and continuous progress with reforms and infrastructure improvements would bring a continuous flow of economic benefits. (See, "Analysis of economic and political prospects," below.)

  WTO membership will slowly increase competitive pressures that it is hoped will force Chinese industry and finance to rationalize to meet international standards. However, the survey asserts that neither the debt nor the equity sides of the financing mechanism are functioning well enough to provide the financing needed for so much reorganization. The major banks are mired in politically directed non performing loans that continue to increase - corporate governance does not inspire confidence in equities - and the government's finances are increasingly burdened with deficits and formal and informal guarantees.

  The U.S., too, is currently grappling with corporate governance problems, but is certain to succeed because appropriate corporate reforms are now the only way for corporations to again be rewarded with higher price/earnings multiples.

  Instead of widespread starvation - as many Malthusians so recently predicted - Chinese agriculture now suffers from mounting unmarketable surpluses. The problem is "far too many people cultivating far too little land which they can neither sell nor mortgage." Prices are 20% to 40% above world prices to accommodate China's inefficient small plot farms. China's rural prosperity is threatened. Boosting - or even maintaining - agricultural incomes without moving most of China's many hundreds of millions of farmers off the land so farm size can be increased is simply not possible since there are no alternative sources of employment available for them.

The politicized collectivist management and conglomerate structure of the township and village enterprises is neither efficient nor flexible enough to respond effectively to rapidly shifting competitive pressures.

  And, now, the township and village enterprises that have contributed so much to China's growth are under pressure and frequently in decline. The politicized collectivist management and conglomerate structure of these enterprises is neither efficient nor flexible enough to respond effectively to rapidly shifting competitive pressures. Here, too, needed restructuring is undermined by China's dysfunctional financial sector. Central government taxes have been increasing at a rate that is undermining the townships and villages, which in turn have been resorting to various "fees" on private activities. These fees have reached burdensome levels and cause widespread rural discontent.
 &
  China's statistics - especially regarding unemployment and debt and government guarantees - are sharply disputed by The Economist. Unfunded pension liabilities are mounting rapidly.

Some pertinent history:

The emphasis on social orderliness, learning, high moral standards and the fulfilling of commitments materially aids market functions. Confucian tradition also emphasizes loyalty to family and social affiliations that can extend to a business enterprise. There is an abundance of human capital in all Confucian countries.

&

  The written Chinese language goes back about 5000 years. The characters used are based on shapes of objects rather than - as in Europe - on the sounds of words. This "explains why the Chinese have a different way of thinking."

  We think our abstract thoughts in terms of words. A written language elaborating itself on the basis of analogy promotes a style of thought heavily dependent on analogy. In Western analytical processes, analogy is generally a subsidiary form of reasoning - an aid to explanation more than a method of analysis. Analogy is frequently used more for rationalization than reason.

  Evidence of skilled labor and entrepreneurship runs back at least 4000 years. Chinese literature and philosophy were in full flower 3000 years ago.
 &
  Confucian tradition from that period is still a powerful economic influence. The emphasis on social orderliness, learning, high moral standards and the fulfilling of commitments materially aids market functions. Confucian tradition also emphasizes loyalty to family and social affiliations that can extend to a business enterprise. There is an abundance of human capital in all Confucian countries.
 &
  On the other hand, respect for tradition can hinder progress and block the flexibility needed to respond to rapidly changing circumstances. Personal honor is a poor substitute for modern enforceable legal rights as a safeguard for business commitments under modern economic conditions. The lack of individualism and individual incentives reduces flexibility and hinders progress.
 &
  Chinese history also contains instances of fierce suppression of intellectual freedom by rulers intent on establishing and maintaining despotic control. Despotic power has frequently been used to undertake vast projects. Mao Zedong was heavily influenced by these traditions and consciously followed them.
 &

    Military expansion has not historically been a primary interest of Chinese rulers, although they have received tribute from such neighbors as Korea and Vietnam. (The interests of China's Mongol rulers were a different matter.) China had neither the energy nor motive for further expansion. Today, Taiwan is viewed as an internal matter.

  "As the world's most populous and third largest country, China will gain economic and political influence in the twenty-first century by the natural course of its rapid economic development. It would be self-defeating to rock the boat by engaging in risky military adventures."
 &
  Chow asks where China might be interested in expanding? If Russia further implodes, there are vast resource rich, lightly populated regions in Central Asia and Siberia beckoning across China's long western and northern borders. China already presses claims to the resources of the entire South China Sea right up to the territorial waters of the Philippines, Vietnam and Indonesia.

There has been a conspicuous failure to exploit China's many outstanding technological achievements.

  Free markets, too, appear in early Chinese history, along with literature explaining and expressing appreciation for their characteristics. China's market economy was well developed a thousand years ago.
 &
  However, there has been a conspicuous failure to exploit China's many outstanding technological achievements. Cheap labor - an intellectual climate that stressed the classics and the achievement of government position rather than commercial enterprise - and lack of financing mechanisms for expensive initial development - are some of the reasons that have been suggested for this important economic failure. (How about the conspicuous lack of individual freedom and property rights?)
 &

It is difficult to abolish the economic institutions and change bureaucratic behavior established under central planning.

The lack of democratic traditions - the lack of traditions of individual civic responsibility - still influence Chinese political development.

  Before Communist rule, China had a market economy, well more than half of which was an agricultural sector dominated by small family farms. Farming was labor intensive but very well adapted to natural conditions. Handcrafts and trade were also extensive. In coastal cities like Shanghai and Tienjin, there were modern economic institutions evolving naturally in a market economy despite considerable political instability.

  "This explains why China was capable of returning to a market economy after economic reform started in 1978. In some respects, including the institutional structure and functioning of the commercial banks and of many industrial enterprises, the current state has not yet reached the high point achieved in the 1930s because it is difficult to abolish the economic institutions and change bureaucratic behavior established under central planning."

  However, efforts prior to WW-II to establish a functioning political system proved unsuccessful and chaotic. "Different parts of China were controlled by different leaders and they did not agree on the person to serve as the president." There was no tradition or understanding of modern democratic institutions, and attempts at democratic reforms failed. The lack of democratic traditions - the lack of traditions of individual civic responsibility - still influence Chinese political development.
 &
    "Nationalism is a very important force guiding China's policies for political and economic development at present, and it will remain so in the future." Notwithstanding serious mistakes, Mao Zedong is highly regarded for unifying the nation and establishing social order - factors essential for modern development.
 &

The Communist economy:

  It controlled all physical productive resources - land, buildings, machinery and other capital goods. It could assign production targets to farms and factories under its jurisdiction. It directed the supply of inputs and assigned workers. It controlled all consumer goods and the rationing of food grains, vegetable oil, meat, sugar, and cotton cloth. Both rationed and non rationed goods were sold through Commission stores.
 &
  The Commission set labor wage rates and offered job security. It established a system for farm compensation based on farm output and "work points." This was supplemented by allocations of farm produce over and above that required to be sold to the Commission procurement agency at prices fixed by the Commission through the State Price Commission of the State Council.
 &

The central planning authority required vast masses of information on the production conditions of all controlled enterprises and the economic demands of hundreds of million of consumers. It had to choose thousands of products to produce, assign production quotas to thousands of enterprises, and supply them with needed inputs.

  Without market guidance, the central planning authority required vast masses of information on the production conditions of all controlled enterprises and the economic demands of hundreds of million of consumers. It had to choose thousands of products to produce, assign production quotas to thousands of enterprises, and supply them with needed inputs. This is all an obvious impossibility.
 &
  Without markets, another impossibility is the fixing of rational prices. "In practice the prices of consumer goods in a planned economy tend to be set too low because of a sense of fairness. Demand therefore tends to exceed supply, and shortage results."

  It has been noted that centrally planned economic systems distribute shortages - which enable officials to charge rents - receive bribes - for scarce products and services. "Fairness" is just the excuse.

  Failure to establish prices that could balance revenue with expenses for multitudes of various enterprises meant that there were either financial surpluses to be turned over to the planning authority or subsidies needed from the authority. Under central planning with no competition, most enterprises produced financial surpluses. After introducing market reforms, most became money losers. In either case, of course, there is an impact on the government budget that has to be taken into account.
 &

Another impossibility is the allocation of appropriate incentives to state enterprise managers to induce efficiency, appropriate expansion of capacity, and effective development of new products.

The planning process became subject to delays, frequent revisions, and a lack of reality.

  Without profits and market wages and salaries, another impossibility is the allocation of appropriate incentives to state enterprise managers to induce efficiency, appropriate expansion of capacity, and effective development of new products. "However, it is difficult for the planning authority to judge which enterprise managers should be rewarded when the production targets are set arbitrarily and the economic conditions of the enterprise cannot be ascertained accurately."
 &
  Managers can't receive sufficient rewards for investment risks "because the reward for success is limited while punishment for failure is severe." When results are ambiguous - as is usually the case for major plants and infrastructure projects - incentives perversely favor wasteful levels of investment and inputs to assure the appearance of success.
 &
  Thus - unsurprisingly - central planning bureaucracy strangled individual initiative. Output targets quickly became unrealistic and disconnected from the supplies allotted and actually delivered. The planning process became subject to delays, frequent revisions, and a lack of reality.
 &
  A 1961 survey at one factory described tools acquisition as "short in supply, slow in production, poor in administration, and wasteful in utilization." As much as 25% of tools acquired were never used because of duplicate ordering, mistakes in design or production, or lack of parts. This machine tools factory used 545 different kinds of steel. Materials shortages combined with mismatches in specifications to greatly increase shortages of needed supplies.
 &
  Nevertheless, because of China's vast pool of cheap labor and a lack of competitive pricing pressures, these grossly inefficient facilities were still able to spin off substantial "profits" for the government budget. In 1980, the Chinese government received 43% of its revenue from state owned enterprises ('SOEs").
 &

Communist party committees existed at all levels of each enterprise, leaving vague the division of authority and responsibility between management and Party committees.

  SOEs had a dual management system. Communist party committees existed at all levels of each enterprise, leaving vague the division of authority and responsibility between management and Party committees. "Interference by party members in administrative matters is a serious problem in Chinese industry, especially when members do not have the required educational background or administrative experience to play a leadership role." (They also bear no personal financial responsibility for the impact of their actions.)
 &
  Economic reform ultimately attempted to deal with these problems by introducing market mechanisms - transforming the centrally planned economy into a "socialist market economy" that Chow more accurately describes as a "bureaucratic market economy." Initial reforms shifted emphasis from output targets to profit maximization, thus bringing cost calculations into production decisions. However, in the absence of personal incentives to achieve profitability, these early reforms achieved little.
 &

An incentive problem arises because the farmer is not paid according to the marginal product of his labor.

For industry, the lack of incentives was joined by widespread mismatches of jobs and workers and inputs.

The labor bureau staff will often assign the more desirable jobs as compensation for favors.

Industrial planning was plagued by perverse incentives.

Standard economic theory is applicable to the Chinese Communist experience, Chow emphasizes. 

• Chinese consumer demand reacted to the mix of rationed and non rationed goods as expected of rational consumers.
• The vast agricultural sector - over 800 million people divided into over 53 thousand communes with almost 700 thousand brigades and more than 5 million teams - was all directed by the central planning authority to grow particular crops and produce particular amounts of light industry goods with specific allocated inputs, and engage in major infrastructure projects. However, "an incentive problem arises because the farmer is not paid according to the marginal product of his labor." There was little incentive to work hard.
• For industry, the problems were even worse. The lack of incentives was joined by widespread mismatches of jobs and workers and inputs. Pay increases were nonexistent between 1960 and 1977, but bonuses and other rewards were sometimes given. As one would expect, the result was a lack of incentive and low worker productivity.

  "Furthermore, the government's labor bureau is less qualified than an enterprise's personnel manager to decide whether a particular worker is suitable for a certain job. The labor bureau staff will often assign the more desirable jobs as compensation for favors. In addition, once assigned a job, the worker cannot be discharged, and she gets the same pay whether she works harder or not."

• The central planning authority's lack of applicable expertise frequently led to major and minor economic disasters.
• Industrial planning was plagued by perverse incentives. Management had an incentive to provide low estimates of productive capacity to assure it would be assigned low quotas that it could easily meet. There was no incentive to increase production or introduce new products. Management had an incentive to overestimate needed inputs to avoid penalties for failing to meet production targets. Whenever abundant inputs were provided - something that frequently didn't happen - there was no incentive to prevent wastage of those resources. "Waste of material and other inputs will result, [as will] the accumulation of large inventories."

Political organization:

&

Further confusion was created by the powerful committees of the Communist Party which ran parallel to government agency organization from the State Council right down to the factory floor and commune.

  The State Council heads the executive branch of the government. It had 40 ministries and bureaus controlling various economic functions. Coordination was under the State Planning Commission, while evaluation was under the Economic Commission.
 &
  Central Planning covered important consumer and producer goods - food grains, vegetable oils, meats, eggs, consumer durable goods, industrial materials, and capital goods. However, in practice, the system was never this neat. Sometimes, production targets were simply assembled from submissions from individual communes and enterprises. Usually, planning was a mixture of unit submissions and central planning authority directives. Often, planning directives came from both the central planning authority and individual provincial agencies. Further confusion was created by the powerful committees of the Communist Party which ran parallel to government agency organization from the State Council right down to the factory floor and commune. 
 &

The central planning authority:

 There is no incentive and no mechanism to transfer the excess material from one enterprise to another.

  Lacking market mechanisms and profit incentives, the central planning authority faced an impossible task in balancing material resources throughout the economy.

  "Often the balance between the production and the use of each product is achieved only on paper. When actual production takes place, some materials may be in short supply, creating bottlenecks in production, while other materials may be in excess supply, creating large inventories. Excessive inventories held by one enterprise may not be made available to another enterprise that needs them; there is no incentive and no mechanism to transfer the excess material from one enterprise to another."

The planning authority frequently failed to understand the economic constraints limiting its choices. "Grossly unrealistic economic plans that cannot be implemented is not unusual." Perverse incentives permeate this massive bureaucracy at all levels. The self interest of lower level economic administrators frequently doesn't coincide with those of the national authority, creating serious problems.

  Since politics took precedence over economics, the planning process was periodically disrupted by political storms. The supply ministry had specialized material supply corporations and stations, processing factories and service teams within each province and autonomous region. There were periodic shifts in organization in efforts to improve matters, but the ministry was smashed during the Cultural Revolution.
 &
  Provincial, municipal and autonomous regional authorities always distributed between 10% and 30% of producer goods through market channels. After the death of Mao Zedong, local authorities were given control of substantial percentages of even basic resources like rolled steel, copper, aluminum, lead, zinc, timber and cement.
 &
  The objectives of the central planners determined how prices were set. For example, basic consumer goods like rent and food grains were priced low to assure that all could afford them. This meant that government subsidies were required for the producers and scarce supplies had to be rationed. Prices of discretionary  consumer goods like TV sets were set high to discourage consumption. Prices of basic materials were fixed to prevent price inflation. Farm inputs were priced high as a tax on farms for the benefit of national capital accumulation. 
 &
  Unfortunately, over and above the impossibility of its many tasks, many weaknesses beset the planning authority. It frequently failed to understand the economic constraints limiting its choices. "Grossly unrealistic economic plans that cannot be implemented is not unusual." Perverse incentives permeate this massive bureaucracy at all levels. The self interest of lower level economic administrators frequently doesn't coincide with those of the national authority, creating serious problems.

  "False reporting and receiving bribes for doing favors for the enterprises are not uncommon practices. Often the appointment of staff is influenced by political considerations and not by the candidates' professional qualifications. Once on the staff, a person may use his administrative and economic powers to further his own interests, which may differ from the interests of the central planning authority."

Since 1980, central planning has been reduced to the setting of targets for guidance, and a substantial consolidation and reduction has been achieved in the planning bureaucracy.

  Substantial levels of local administrative power have persisted throughout Chinese history, and the administrative units of different provinces frequently have objectives at odds with those of the central planning authority. Thus, some flexibility did persist. The central control apparatus was never total. Local authorities had varying degrees of discretion to influence operations. They could frequently solve their own production and distribution problems through barter and other arrangements. Before the Cultural Revolution, some price flexibility was also permitted, which also facilitated operations.
 &
  Since 1980, central planning has been reduced to the setting of targets for guidance, and a substantial consolidation and reduction has been achieved in the planning bureaucracy.
 &

Reform:

Agriculture:

Private farming massively increased agricultural productivity and diversity, with especial emphasis on cash crops. The land assignments were ultimately made permanent and transferable - and almost all of this huge sector of the Chinese economy returned to the private market sector.

  The failure of central planning for agriculture was obvious. "Farmers were more knowledgeable about what crops to plant on their land than political leaders and economic planners." The lack of incentives for hard work undermined productivity.
 &
  Reform of agriculture was a bottom-up process. Farm communities informally decollectivized under the guise of a "household production responsibility system," whereby households were assigned land - required to meet a delivery quota to the commune - but otherwise were left free to engage in farming and handcrafts for themselves and for the market. In 1979, this system was officially recognized and adopted.
 &
  Private farming massively increased agricultural productivity and diversity, with especial emphasis on cash crops. The land assignments were ultimately made permanent and transferable - and almost all of this huge sector of the Chinese economy returned to the private market sector. With the success of agricultural reforms, at least the food supply and food pricing stability was assured, and a stable foundation for further reforms had been created. 

  The communes were everywhere an immediate economic disaster. However, for despots like Mao and Stalin, they successfully achieved the vital political goal of establishing complete control over the peasantry. So, they were retained in China during Mao's lifetime and for six disastrous decades under Soviet Russian despots.

Township and village collectives:

As with private farming, the township and village collectives were an unexpected advantage of  the early reforms.

  These collectives are financially accountable. They are intended to earn a profit and must operate under firm budget constraints. They can hire and fire workers and pay market wages and salaries, and are subject to competition from other producers. 
 &
  Since 1992, some of these collectives have been reorganized into employee and local government owned joint stock companies to try to gain the benefits of a substantial private ownership interest.
 &

State owned enterprises ("SOEs"):

Autonomy, some reliance on market pricing, competition and profit retention were simply not enough. There remained a lack of managerial know-how and appropriate managerial incentives.

"The appropriate link between marginal profits and the manager's marginal benefits remains a serious problem in enterprise reform in China."

 The managers are still underpaid. They were bureaucrats appointed by a board of directors which consisted of the same government and Party officials as before. The government board had neither incentives nor ability to monitor the behavior of the enterprise managers.

  First, in 1984, SOEs were given some autonomy with regard to production, supply, marketing, pricing, investment, and personnel..
 &
  Second, they were given financial independence,  "as independent profit-seeking economic units."
 &
  Third, in 1987, a contract responsibility system was initiated whereby they could keep their profits after fixed taxes.
 &
  Fourth, market pricing was gradually initiated except for scarce resources, which were allocated through market pricing broadly, but through preferential below-market prices for designated users.
 &
  Fifth, SOEs began to be restructured into shareholder companies.

  "The reform of state enterprises, unlike the privatization of Chinese agriculture, require an overhaul of the entire Chinese planned economy. The price system has to be made more market determined. Otherwise, profits of enterprises could not reflect economic efficiency. Yet the notion of government giving up price control was not acceptable to most economic officials in the early 1980s. The planning apparatus had to be scrapped, or at least greatly modified, which was also an unacceptable notion to many government officials."

  Thus, the initial 1984 reforms were both revolutionary and limited in scope, "because it was not possible to go further." But by 1987, the "contract responsibility system" was introduced.
 &
  However, autonomy, some reliance on market pricing, competition and profit retention were simply not enough. There remained a lack of managerial know-how and appropriate managerial incentives. (The reforms achieved only limited success because they still did not provide for private ownership and legally enforceable property rights, and retention of profits by private risk-bearing individuals.)

  "The appropriate link between marginal profits and the manager's marginal benefits remains a serious problem in enterprise reform in China."
  "The managers are still underpaid. They were bureaucrats appointed by a board of directors which consisted of the same government and Party officials as before. The government board had neither incentives nor ability to monitor the behavior of the enterprise managers. It is alleged that political considerations entered heavily in the appointments to large state enterprises, and that foreign competition from China's membership in the World Trade Organization was brought in to force the inefficient state enterprises to improve their performance."

Rapid reform of SOEs would  pose significant unemployment problems.

  Nevertheless, some significant increases in total factor productivity and operational efficiency are observable as a result of the reform effort. Moreover, for smaller and medium sized SOEs transformed into employee owned corporations, results were better. They behaved more like similar enterprises in less developed capitalist market economies due to similar management, worker compensation and other incentives.
 &
  As of 1996, SOEs contributed less than 30% of gross industrial output - about 22.6% of GNP. However, they still employed about 56.7% of urban workers. Rapid reform of SOEs would thus pose significant unemployment problems. The private sector and the collective sector contributed over 70% of gross industrial product.
 &

Private enterprise:

&

  Individual owned and overseas funded enterprises have also achieved significant proportions, so that SOE production - although also expanding - has nevertheless shrunk proportionately from over three quarters of gross industrial output to about one quarter.
 &
  By the 1990s, most products were being sold at market prices. Most urban housing was privatized by the end of the century. Foreign trade and foreign investment were facilitated and rapidly expanded to significant levels. Foreign trade equaled 37% of GDP by 1998.
 &

Foreign investment:

As a result, modern managerial systems and business practices have been introduced, and a legal framework for conducting business transactions has been developed. China thus also reaps the many rewards of heightened competition in domestic markets.

Nevertheless, many Chinese officials remain antagonistic to market mechanisms, and restraints and interferences of various kinds will remain.

There is no western style legal system, and the Chinese have their own habits, ethics, outlooks and training. The economic power is in the hands of the bureaucrats, and they are looking to make money from their positions. It is thus essential to find the right people for bureaucratic approvals and as partners.

If Chinese partners can learn your technology, they can set up competing businesses without you.

  China thus gets capital, new technology, and managerial and labor skills. As a result, modern managerial systems and business practices have been introduced, and a legal framework for conducting business transactions has been developed. China thus also reaps the many rewards of heightened competition in domestic markets.
  China is the third largest recipient of foreign direct investment. While most still goes to eastern coastal regions, more is beginning to reach central and western regions. By 1999, foreign direct investment accounted for 10% of Chinese urban employment. Foreign invested enterprises now contribute over 20% of China's industrial value added, significant export surplus and tax takings for the government - and they are growing rapidly.
 &
  Under WTO agreements, financial and telecommunications sectors will open, agricultural and industrial product tariffs will decline, and foreign markets will open to Chinese goods. Nevertheless, many Chinese officials remain antagonistic to market mechanisms, and restraints and interferences of various kinds will remain. In 1995, as revised in 1997, China promulgated the Interim Regulations on FDI Directions, and the Industrial Catalogue Guiding Foreign Investment. These set forth items to be encouraged - items to be permitted - items to be discouraged - and items to be prohibited. At least, there are now express ground rules.
 &
  Encouragement is generally directed at introduction of advanced technology - export industries - investments in central and western regions - comprehensive agricultural development - energy industry projects - transportation - vital raw materials - and projects renewing resources and curing pollution. Various service sectors are also being opened to foreign investors.
 &
  However, in China's "bureaucratic market economy," investors must keep in mind that getting along has special requirements.

• An investor must find and choose the right partners. There is no western style legal system, and the Chinese have their own habits, ethics, outlooks and training. The economic power is in the hands of the bureaucrats, and they are looking to make money from their positions. It is thus essential to find the right people in the various bureaus, as well as help from Chinese labor and management.
• China's legal system is slowly improving, but agreements still depend on mutual relationships - "guanxi" - and the maintenance of influence and usefulness.
• Patent and copyright protection is ineffectual, and the pirating of intellectual property and technology is a widespread practice. This is a fact of life in China that investors must take into account. If Chinese partners can learn your technology, they can set up competing businesses without you.
• SOEs and provincial and local governments can make useful partners.
• There are many roadblocks. Corruption requires bribes of many kinds. Many regulations must be navigated. Government controls on foreign exchange and interest rates, and imperfections in the domestic financial markets, must be dealt with.

  It is expected that much of this will improve under WTO membership.

  Chow questions the benefits of patent protection for medicinal drugs. The paucity of new drugs for treatment of devastating tropical diseases is no accident. The U.S. - through the temporarily high prices in its patent protected market - subsidizes drug development for the whole world - but only for diseases prevalent within the U.S.

Foreign trade:

&

Once resources are not priced by the competitive forces of demand and supply, it is difficult for any planner to make economically correct decisions concerning what to produce, how much to produce, and what and how much to export and import, not to speak of the need to provide proper incentives to the economic agents to carry out their tasks.

With free trade and market rates for foreign exchange, there can not be a shortage of foreign exchange.

  Initial efforts at foreign exchange controls achieved predictably poor results. During the 1990s, foreign exchange rates were instead set close to the Hong Kong market rate of 8.3 yuan to the dollar. Chow explains the difficulties and inefficiencies involved in China's early efforts at exchange rate and foreign trade controls. He compares this with the ease and benefits of Hong Kong's free trade, low tax policy.

  "Once resources are not priced by the competitive forces of demand and supply, it is difficult for any planner to make economically correct decisions concerning what to produce, how much to produce, and what and how much to export and import, not to speak of the need to provide proper incentives to the economic agents to carry out their tasks. In the 1990s the Chinese government came to appreciate the usefulness of market forces in the regulation of the economy. It instituted reforms to decentralize production for the domestic as well as the foreign market."

  The author explains the limitations and inevitable failures of protectionist industrial planning measures. Whether protecting "infant industries" or "declining industries," protectionist measures may favor some owners and workers, "but they are bad in general for the consumers of the countries concerned."

  "Foreign trade has enabled the low-cost and high-quality labor in China to produce goods to be sold at higher prices in the world market, thus increasing the compensation of Chinese labor. It has also enabled the import of technology and high-quality capital goods for use in production in China, as well as the import of high-quality consumer goods. The availability of high-quality capital goods improves productive efficiency. The availability of high-quality consumer goods not only increases consumer welfare directly; it also acts as an important competitive force in the Chinese consumer market and stimulates improvement of the quality of domestically manufactured products."

  With free trade and market rates for foreign exchange, there can not be a shortage of foreign exchange.

  "More funds, including foreign exchange, can be obtained by taxing a rich economy at low rates than by controlling a small amount of foreign exchanges earned by an unproductive economy." 

   Currency stability was maintained during the Asian financial crisis due to China's low inflation rate, a substantial trade surplus, and inflows of foreign direct investment. These factors continue.
 &

Trade liberalization:

The reduction of trade and investment restraints will be gradual, and the central, provincial and local governments retain many regulatory powers with which they can hinder foreign competition. There is as yet no great rush of foreign interests to push their way into the Chinese market.

  WTO membership and consequent reductions in trade restraints during the next five years are expected to benefit Chinese consumers by increasing quality and reducing prices of goods and services. Competition will force Chinese producers to lower prices and improve quality. However, many may not be able to adjust sufficiently to survive.
 &
  It is hoped that foreign competition will combat inertia among managers in both the SOE and state banking sectors. However, the reduction of trade and investment restraints will be gradual, and the central, provincial and local governments retain many regulatory powers with which they can hinder foreign competition. There is as yet no great rush of foreign interests to push their way into the Chinese market.
 &
  Because of this inertia, Chow believes that China's gains from WTO membership will be modest.

  "Besides the formal provisions to open China's economy gradually, the central government is monitoring the speed of changes to avoid social instability. At the same time, the local governments and bureaucrats will slow the changes with red tape if they find them too threatening to local economic institutions."

Education and the legal system:

Regard for the law and courts is low. The result of decades of Communist rule has been a widespread acceptance of illegal activity - something that was often essential for survival under Communism.

  Development of a modern legal system is also being attempted - but with considerably less success. A wide array of financial and commercial laws have been passed. The judicial system has been expanded, and lawyers have been trained, and the courts are deciding more cases - including suits against the government.
 &
  However, the Communist Party remains above the law, and judges still accede to the wishes of the Party and government officials involved in litigation. Chinese culture still rejects legalistic processes in favor of Confucian morality based on honoring relationships. And inertia still dominates commercial processes. Regard for the law and courts is low. The result of decades of Communist rule has been a widespread acceptance of illegal activity - something that was often essential for survival under Communism.
 &
  Chow acknowledges that the rules of conduct for individuals and enterprises must be specified and enforced for a free market to function properly. That being said, each nation and culture will vary in their rules and enforcement and dispute resolution mechanisms. Law must evolve with the evolution of the economy and its institutions. This process is now under way in China, but clearly has a long way to go.
 &
  The author notes advantages in the "moral-social system" for enforcing agreements. Moral enforcement and social pressure are certainly less costly and time consuming than litigation. 

  However, such enforcement is totally inaccessible to those outside the guanxi social relationship networks. This greatly diminishes the pool of entrepreneurial talent available to the economy.
 &
  Actually, the difference is not as stark as Chow presents it. The vast majority of Western capitalist commercial flows depend on little more than telephone calls and internet messages and established courses of conduct. Even where there are written contracts, they are almost never without various ambiguities filled in by established commercial practices. Trust - a reputation for credit worthiness - is a vital factor in Western capitalist commerce.
 &
  The enforceability of Western criminal law is also not  absolute. Enforcement requires acceptance by the public and assistance in the enforcement effort. The difficulties of enforcing prohibitions against alcohol and illicit drug use are notorious examples. Juries will not convict - or will not award substantial civil damages - if laws are not widely acceptable.

The Taiwan model:

Essentially, freedom and economic opportunities, however incomplete, succeeded in developing the Chinese economy.

  Interestingly, much of this reform effort was copied from the successful earlier Taiwanese example. "Essentially, by giving freedom and economic opportunities, however incomplete, to the Chinese people, the government of both regions of China succeeded in developing the Chinese economy." The promotion of exports was similar to the earlier Taiwanese approach, as was the emphasis on price stability, the lifting of import restrictions, and the setting of monetary exchange rates close to market rates while maintaining monetary discipline.
 &
  However, bureaucratic obstruction and corruption and the role of SOEs remain considerably higher on the mainland.
 &

Interim results of reform:

The Chinese people have greeted economic freedom enthusiastically, and used it with entrepreneurial and managerial skill - just as they have done outside China for many decades.

  The reform effort has proceeded gradually through pragmatic pursuit of experimental policies. Success has depended crucially on the determined reforming emphasis of China's top leadership since 1978. The exact statistics have been questioned, but the visible results are indisputable.

  "It should be pointed out that the political process practiced in China has been capable of selecting and promoting able and, especially, college-educated people in the government, but the process has not been perfect and the economic system itself has bred corruption."

  It should also be noted that the Chinese people have greeted economic freedom enthusiastically, and used it with entrepreneurial and managerial skill - just as they have done outside China for many decades. Success has supported further reform. Thousands of overseas Chinese have also contributed financial capital and know how. Today, about three quarters of the Chinese economy is market driven.
 &

Problems with the bureaucratic market economy:

Bureaucratic approvals absorb money, effort and time. The scope of an enterprise can be restricted, both as to activities and size permitted. It is still impossible for a private enterprise to grow large.

  Corruption and other means of acquiring economic rents continue despite preventive efforts and the occasional execution of offenders. Bureaucratic approvals absorb money, effort and time. The scope of an enterprise can be restricted, both as to activities and size permitted. It is still impossible for a private enterprise to grow large. This is what Chow accurately describes as a "bureaucratic market economy."

  "Thousands of world-class entrepreneurs in China have their hands tied by the political and bureaucratic environment when they wish to use their talents for self-fulfillment and for the modernization of the Chinese economy. Some of these people have to channel their energy through the government political and economic organizations, - - -. WTO membership may help reduce bureaucracy and promote rule of law, creating a slightly more level playing field. In the process, the conflict between state bureaucracy and nonstate enterprises may be partly resolved to benefit the Chinese market economy."

Assets under government care deteriorate over time.

Rent seeking is a natural substitute in socialist systems for the profit motive.

Where money bribes are dangerous or inconvenient, "guanxi" - relationships of mutual favors - proliferate.

Without income incentives for effort, labor productivity was everywhere low and the quality of services was everywhere poor.

"The people are humiliated continuously by bureaucrats who control assets yielding services necessary for daily living."

  The misuse of labor, physical assets, and human capital under the Chinese bureaucratic market system, and the perverse incentives of socialist systems, are analyzed by Chow.

• Managers that have little personal benefit to gain from the maintenance of assets will put little or no effort into their maintenance. Thus, assets under government care that require active maintenance will deteriorate over time (or cost inordinate amounts to maintain).
• Rent seeking - the expectation of bribes to provide timely and/or quality services - is a natural substitute in socialist systems for the profit motive whenever personal risks are not too great. Corruption among permitting bureaucrats and managers who control government productive assets is widespread. "When opportunity arises, the asset manager will try to extract rent, often illegally, for the service rendered." Permitting powers - import and export licenses, inspection permits, permits to engage in particular economic activities - provide powerful rent seeking opportunities. Bribery has increased in China since the reforms, because increased economic activity has increased demand for permits that are still required.
• Where money bribes are dangerous or inconvenient, "guanxi" - relationships of mutual favors - proliferate. This has been a traditional practice in China, but was made much worse under Communism.
• When asset managers do not benefit from delivery of goods, delivery will be late and/or the goods will be shoddy. 
• Before reforms provided income incentives for effort, labor productivity was everywhere low and the quality of services was everywhere poor.  Chinese studies have affirmed that Chinese farmers responded favorably to income incentives after reform.
• The lack of labor mobility undermined the productivity of human capital and reduced incentives to invest in training and education to improve human capital. Instead, perverse incentives favored efforts to gain political connections and rent seeking positions.
• "Each bureaucrat abuses his right in managing assets and provides poor services to those requesting them if the services provided yield no benefit to him." Poor services reduce demand and thus the service providers workload.
•  "The people are humiliated continuously by bureaucrats who control assets yielding services necessary for daily living."

"Corruption is still prevalent and the end of it is not in sight."

  Even after reforms, state control over economic resources remains high. Socialist controls over economic assets - including controls over human beings - and restrictions on their use impose a variety of negative effects on productive activities.
 &
  Nonstate cooperatives and private enterprises still face daunting layers of bureaucratic red tape and rent seeking. "Corruption is still prevalent and the end of it is not in sight."
 &

Problems with SOEs:

&

The system does not provide SOE management with appropriate incentives. Management is generally of low quality and self interested. Their pay is considerably less than in the other sectors of the economy, and the SOEs lack suitable governance systems.

  Although improvements have in fact been made, the SOEs remain a problem. Several social entitlements interfere with reform efforts. SOEs provide not just jobs and wages, but pensions, housing, education and health care.

  "They require government subsidies; the entitlement of staff and workers is a drain on the government budget and economic resources. And the entitlement includes more than their wages: the entire support system, including schools for their children, healthcare for their families, and retirement benefits, is very costly. Reducing the size of the enterprises creates an employment problem."

  Reality confirms theory. The system does not provide SOE management with appropriate incentives to work for the benefit of the enterprise. Management is generally of low quality and self interested, weaknesses that were "magnified under the institution of central planning." Their pay is considerably less than in the other sectors of the economy, and the SOEs lack suitable governance systems. Competition has forced some productivity improvements, but both physical and human capital remains very outdated.

  The U.S. is having some problems with management pay, too. However, in the U.S., the problem is overpayment at the top - which appears to be far less damaging to an enterprise than underpayments for the bulk of lower and middle management. In the U.S., any corporation that fails to adequately deal with these problems is eventually punished with low p/e multiples.
 &
  Mismanagement exists in the U.S., too. However, it is kept in check by "the right to fail," which becomes especially fierce during periodic recessions. Without periodic weeding out of mismanagement, it just proliferates.

"Since the marginal benefit of producing extra output belongs to the farm household, there are great incentives to produce."

In small enterprises, where managers paid a rent and kept the profits, they quickly began to pay higher wages to their most productive workers, and output quickly soared. In SOEs, where practical, shifts to piecework pay or to "leasing" arrangements resulted in rapid increases in production.

  The "Responsibility System" was started at the beginning of the reform effort when farmers were given the right to farm land distributed to them in return for meeting a product delivery quota. The effect was the same as in a market economy where farmers work leased land and can keep all the profit after paying rent and other expenses. "Since the marginal benefit of producing extra output belongs to the farm household, there are great incentives to produce."
 &
  This was extended to small enterprises, where managers paid a rent and kept the profits. They quickly began to pay higher wages to their most productive workers, and the output of goods and services quickly soared. In SOEs, where practical, individual units shifted to piecework pay or to "leasing" arrangements - resulting in rapid increases in production.
 &
  However, these types of arrangements worked unsatisfactorily for large SOEs as a whole, because of several factors.

• Ideology prevented top managers from being paid fully for their positions.
• Lack of an ownership interest and lack of a competitive environment - many SOEs have monopoly power - left profits an unreliable guide to success.
• There are no objective standards for rationally calculating tax or rental rates.
• Prices for many inputs are still administered rather than set by market mechanisms.

Proper supervision of management performance remains impossible for lack of objective standards of success. Since cognizant government officials don't risk their own funds in the SOEs, there is no incentive to find capable managers.

 Appointments are made on the basis of political influence. There is no penalty for these officials if SOE shares suffer low p/e ratios. Failure is routinely overcome with subsidies.

  Restructured SOEs under the responsibility system still suffer from majority government ownership and government appointment of managers and directors. Proper supervision of management performance remains impossible for lack of objective standards of success. Since cognizant government officials don't risk their own funds in the SOEs, there is no incentive to find capable managers. Appointments are made on the basis of political influence. There is no penalty for these officials if SOE shares suffer low p/e ratios. Failure is routinely overcome with subsidies.

  "Many of the managers are bureaucrats assigned historically - - -. They have been given vested interests through the bureaucratic system and cannot be easily removed. Even the Prime Minister finds it difficult to change these incompetent and sometimes corrupt managers."

  A variety of ownership reforms are underway. For some SOEs, shares were sold to workers and managers, but transfers of those shares were permitted only between those shareholders. For other SOEs, transfers are permitted to the general public, and some have their shares traded on Chinese and even international stock exchanges. Central and provincial governments retain controlling interests in many SOEs, but some were sold to overseas Chinese and other foreign owners.
 &
  This is a work in progress, Chow points out. It has already achieved many improvements, but clearly has a long way to go. Changes in ownership structure haven't led to changes in incumbent managers, or forced changes in management practices.
 &

Problems with banks:

There is still political pressure and economic temptation to extend credit at higher risk than benefit-cost calculations justify.

  Banking law has been considerably reformed, but actual practices remain governed by political and bureaucratic considerations.

  "Bank managers still behave like bureaucrats holding onto their economic power. There is still political pressure and economic temptation to extend credit at higher risk than benefit-cost calculations justify. The management and staff need more training and experience before they can operate as modern commercial bankers."

The bad loan problem has not yet gotten out of hand in relation to the financial resources of the government, which is expected to support the system in any crisis.

  The large state owned commercial banks hold about 70% of China's banking assets. They are subjected to credit quotas. About 80% of the loans of the four large state banks are to SOEs - and between 20% and 25% - about $200 billion - are non performing. Nevertheless, the operations still appear to be profitable. They must pay a 33% tax on income and an 8% turnover tax on gross revenue.
 &
  Chow believes the bad loan problem has not yet gotten out of hand in relation to the financial resources of the government, which is expected to support the system in any crisis. The people thus retain confidence in the four large state banks, and high savings rates and a paucity of alternative investment opportunities have assured adequate liquidity for these banks.
 &
  Moreover, monetary growth has been restricted and interest rates kept high enough to keep inflation in check. Most foreign investments in China are direct investments that cannot be withdrawn quickly, and the Chinese currency is not overvalued. Thus, banking and/or monetary crisis in China is currently unlikely.
 &
  Chow analyzes the banking system, recent reform efforts and remaining weaknesses. The system is not yet modern, and thus lacks the tools available in advanced economies.
 &

Poor customer service, corruption, misuse of bank funds for illegitimate purposes or the purposes of bank managers all still exist, although improvements have been and continue to be made.

  The central bank - the "People's Bank" - remains a political executive arm of the central government and lacks independence. In addition to the ordinary activities of central banks, it engages in the allocation of credit in favor of politically favored sectors like the SOEs, and controls interest rates. High rates on certain time deposits and low rates on loans "have forced commercial banks to find risky and possibly illegal outlets for their funds." Bank reserve requirements have been set too low, making it difficult to avoid periodic surges in the money supply and resulting surges in price inflation.

  "It sets targets for money supply, and the interest rates for bank loans and for bank deposits simultaneously. These targets may be inconsistent with the rates of interest as determined by market forces, given the supply of money. In brief, the degree of planning exercised by the central bank might be inconsistent with market allocation of resources."

  The large state-owned commercial banks still lack managerial expertise. "Incentive problems for management and staff, inability to discharge workers, and bureaucratic behavior among the staff are all present." Poor customer service, corruption, misuse of bank funds for illegitimate purposes or the purposes of bank managers all still exist, although improvements have been and continue to be made.
 &
  Like the large SOEs, the state banks have been unable to design "a reward system suitable for the managers of large enterprises," and the lack of adequate pay levels is highly corrosive.
 &

The Chinese government remains slow in allowing "nonstate financial institutions" to flourish. It remains difficult to start a nonstate commercial bank.

  China now also has many rural and urban credit cooperatives, foreign banks and banks from Hong Kong and Taiwan, as well as small commercial banks. The banking system still has many problems, but appears to be functioning and slowly improving.
 &
  There are now a variety of other financial institutions developing in China, including stock markets, insurance companies, and trust and investment companies to attract foreign investors. While stock markets were reestablished in China just in 1992, Chow finds that they are reacting in a normal fashion similar to the Hong Kong and Western markets. However, the Chinese government remains slow in allowing "nonstate financial institutions" to flourish. It remains difficult to start a nonstate commercial bank.
 &

Population:

Population is still growing at about 1 % per year - but this rate is expected to decline further.

  The author points out that the population density in China is less than in most European nations. Indeed, most provinces have relatively low population densities, and it is the highest density provinces that enjoy the highest per capita income. Today, China exports more food than it imports.
 &
  The reduced birth rate is expected to increase the problem of supporting an aging population in China as in most developed nations. Because of the family policy restraints on freedom, and a few other arguments of a more dubious nature, Chow is highly critical of China's forceful efforts to limit population growth.
 &
  The author analyzes the Chinese labor market and its development of human capital through education and training during the various political twists and turns of the last half century.
 &

The central and western provinces:

&

  The government's role involves infrastructure construction, environmental protection, a shift from heavy industry to consumer goods industries, economic reforms, and the promotion of educational, scientific and technological institutions. The infrastructure needs are massive. Transportation, power and water projects along with the development of human capital "will make the economic environment in the west more attractive for domestic and foreign investment," and facilitate market directed commerce. Chinese agriculture still has much room for productivity growth.
 &

Environmental problems:

&

  China has accumulated massive pollution problems that are only beginning to be addressed. (The massive disregard for environmental concerns under Chairman Mao was very similar to that under Soviet Russia and in a wide variety of other socialist states.) Nine of the world's  ten most polluted cities are in China. China has many laudable environmental laws, but like all laws in China, they are poorly enforced.
 &
  Nevertheless, an extensive administrative effort is being made, and many cities have enjoyed improvements in recent years. SOEs are, of course, among the worst polluters, so enlargement of the private sector should be helpful.
 &

Analyses of economic and political prospects:

The model draws attention to such variables as changes in labor force growth or productivity. Government policy reforms and WTO membership may alter investment rates and thus productivity, the evaluation of which can be facilitated by an econometric model.

  The model is also dependent on "normal" overall conditions. Chow eliminates as abnormal the years from the start of the Great Leap Forward through the first years of the Cultural Revolution - 1958 through 1969.
 &
  The author evaluates the prospects for labor and capital. In the next decade, he believes their contribution to productivity growth will be marginally slower. The economic impacts of China's vast abundance of cheap labor is not expected to change during that period.

  "But a large reduction in [total factor productivity] growth is unlikely, since there is still plenty of new technology in the developed world that the Chinese can adopt. There are also further institutional improvements that China can make, although such improvements are expected to be slow."

  Chow  concedes that his forecast for substantial but slightly slower growth could have been just as easily reached without econometric analysis, simply by assuming a slightly slower growth rate and drawing a simple graph. However, the model draws attention to such variables as changes in labor force growth or productivity. Government policy reforms and WTO membership may alter investment rates and thus productivity, the evaluation of which can be facilitated by an econometric model. "Without a model the effects of these changes, and of government policy, cannot be taken into account in a forecast."

  There are, in fact, a wide variety of inherent limitations in macroeconomic econometrics that are generally overlooked. See: "Economic Statistics and Macro Econometrics: The Figures Lie.  Statistical accuracy is necessarily limited by conflicting public and private reporting interests and limitations inherent in the accounting art - something that has become increasingly apparent of late in the U.S., but which has long been a subject of FUTURECASTS articles.
 &
  Despite the high official rates of growth reported since 1978, Chinese statistics may actually be substantial underestimations. As market disciplines replace central planning, and profit driven entities vastly increase as a proportion of the economy, such poorly measured factors as quality and variety improve massively. The great surge in human capital in competitive sectors is also poorly reflected in statistics.
 &
  Of course, a substantial portion of the reported economic increase may be merely due to the gradual inclusion of gray market activities in the formal economy. The author recognizes, for example, that "Chinese peasants are relatively free to build their own houses." Indeed, casual observation about the increase in home living space and acquisition of all manner of consumer durables since 1978 buttress the impressive official growth statistics regardless of any lack of precision.
 &
  Invariably, there is a false sense of precision generated by macroeconomic econometrics. Chow correctly emphasizes how much they reveal, but there is much that they also hide. As Chow candidly recognizes, there are invariably many missing factors - many of them important outcome determinative variables - that must be omitted because they can neither be measured nor estimated - nor expressed as an equation. To make these models fit the economic movements of the past, the impacts of these missing factors are bundled into "residuals" - widely understood as "the quantification of ignorance" - or hidden in mislabeled equivalents.
 &
   However, it is the failure of these models to predict future economic turning points that demonstrate their invalidity. These models poorly reflect or totally ignore many variables especially pertinent to the business cycle - like the accumulating policy blunders of private management and government and the cumulating distortions of powerful noxious incentives in tax statutes.  (See, "Keynesian analysis," below.) Noxious tax incentives currently play major roles in driving debt bubbles, capital asset bubbles, and now the growing bubble in private housing.
 &
  Reality has repeatedly perversely refused to conform to econometric expectations. The ignored outcome determinative variables may be hidden, but they nevertheless continue to operate. With no more predictive capability than simple graphs, these sometimes complex mathematical models are little more than post-hoc speculation.

"It is the sound judgment and knowledge of the forecaster that determine the accuracy of a forecast," whether or not dependent on an econometric analysis.

"Even in the use of econometric models for forecasting, judgment plays an important role."

  Chow candidly acknowledges many of the limitations of econometrics. He wisely refuses to confine his analytical efforts to econometric analysis. "It is counterproductive to confine economics to the use of quantitative methods only by giving up other means of acquiring knowledge."
 &
  He points out that, "applying a valid method of forecasting, two persons may end up with different forecasts depending on the variables they have chosen and the models they have assumed. It is the sound judgment and knowledge of the forecaster that determine the accuracy of a forecast" whether or not dependent on an econometric analysis.

  "Even in the use of econometric models for forecasting, judgment plays an important role. Judgment is sometimes incorporated by changing the intercepts of equations that have been estimated by statistical methods."

Neither the computer nor mathematics have "yet surpassed the human brain" for analyzing such factors.

  If the political situation is as stable and economically progressive as Chow presents it, he has every reason to be optimistic about China's economic future. His analysis is based on a variety of assumptions that appear quite reasonable. A key variable is the slow but impressively determined economic reform efforts of the past two decades.
 &

Chow notes that "there is no need to have 'perfect' institutions to grow rapidly, as long as important market incentives are permitted to operate in important parts of the economy."

China will enjoy growth rates initially at about 7.5% declining to about  6.5%  until 2020. Indeed, even with modestly declining rates of growth, China's real GDP may well catch up to that of the U.S. by 2020.

  Chow ultimately makes a very convincing economic forecast based on his analysis of economic fundamentals - without econometric equations. The existence of market institutions and high quality human capital will drive further economic growth. His positive estimations of the capabilities of China's top leaders, the ability of the Party machinery to continue to bring capable leaders forward and resolve transition problems, and the widespread contentment of the Chinese people with their current economic progress fortifies this optimism.
 &
  The most important government officials are highly capable and motivated to continue the reform effort. They have shown great determination and skill in pushing reforms forward. "The government is aware of its important role in creating an environment suitable for growth."
 &
  Indeed, continued reforms and infrastructure building should assure rapid economic growth through the first two decades of the 21st century. Chow correctly notes that "there is no need to have 'perfect' institutions to grow rapidly, as long as important market incentives are permitted to operate in important parts of the economy."
 &
  However, the inertia of Chinese institutions and customs will put limits on the pace of growth. SOEs and major banks will reform only gradually and will remain problem areas for some time. Obstructionism and rent seeking by bureaucrats and Party officials will continue.
 &
  He concludes that China will enjoy growth rates initially at about 7.5% declining to about  6.5%  until 2020. What has occurred in Shanghai will occur broadly across China. Indeed, even with modestly declining rates of growth, China's real GDP may well catch up to that of the U.S. by 2020.

  Of course, it will be spread to meet the needs of a population about four times as large. And there are differences in character between the two economies that may well persist.

The Chinese economy will become more modern, with private and service sectors increasing as a percent of GDP, and the SOEs and agriculture continuing to grow but declining as a percent of GDP.

  Prospects for broader progress towards modernity are also evaluated. Chow expects continued development of China's legal system - further increases in autonomy of the National People's Congress as it grapples with complex modern legislative tasks - continued improvements in information flows - further development of modern management know how - and the rise to power over time of better educated and informed political leaders.
 &
  How this will play out politically, however, is uncertain. But the author is hopeful that there will be slow further progress in democratic liberalization and human freedoms.
 &
  The Chinese economy will become more modern, with private and service sectors increasing as a percent of GDP, and the SOEs and agriculture continuing to grow but declining as a percent of GDP. A slow pace of change that avoids instability may in fact be the quickest and surest route towards Chinese modernity.
 &

Keynesian analysis:

It does make a difference whether you build pyramids or roads - and whether those roads connect markets or royal palaces.

Business mismanagement and the cumulating impacts of government economic policy blunders play no role in econometric analyses.

Keynesian remedies for the business cycle are just palliatives that fail to address fundamental problems.

No model of capitalist economic systems can be valid if it fails to highlight the roles profits.

  Since Keynesian theory is obviously invalid, Chow's business cycle econometric analysis is invalid, and this entire portion of this book - and all similar econometric texts - is a waste. The many weaknesses of Keynesian theory and macroeconomic econometric models have been frequently set forth in FUTURECASTS, see, Keynes, "The General Theory (I)" (The Elements of the General Theory) and Keynes, "The General Theory (II)" (Interest Rates, Aggregate Demand, and the Business Cycle), but this is a good opportunity to summarize them.

• The "government sector" is clearly not equivalent to the "private sector." Some portion of government activity is, of course, a necessary part of an economy's overhead - and some is desirable - but government productivity is far less than private productivity - as can be plainly seen in such U.S. programs as the Medicare program and the government's housing programs. In China, SOE sector economic activity is not the equivalent of that in the private sector.
• Not all investment is equal. Government facilities can become an economic burden if maintained - like many of the Chinese SOEs - only by government subsidies. Private farms maintained primarily because of subsidies under Western agricultural policies similarly  become liabilities rather than assets. The capital asset bubble - now replaced by an exploding housing bubble - both driven by noxious incentives in the tax statutes - constitute vast waste of resources. It does make a difference whether you build pyramids or roads - and whether those roads connect markets or royal palaces.
• Anything that cannot be expressed as an equation - anything that cannot be measured or estimated - such as factors of quality and variety, the actual value of investments, sweat equity and the self development of human capital, and gray market activities so important in less developed nations - must be omitted.
• The business cycle is caused by the policy errors of  private management and blunders in government economic policy that invariably accumulate during prosperous times. Yet, these play no role in Keynesian econometric analysis. Private mistakes are rapidly reduced or eliminated during recessions - imminent commercial death serves to concentrate the mind, and the inevitable houses of cards come tumbling down. However, politicians and government bureaucrats need not recognize their mistakes. They can escape having to face inconvenient political choices by passing the burdens on to taxpayers or consumers. This can continue until they so burden an economy that recovery without government reform becomes impossible and public anger threatens incumbencies. This occurred during the Great Depression of the 1930s and the intractable inflation of the 1970s.
• Savings increases beyond investment needs have never yet been responsible for bringing a period of prosperity to an end during the two centuries of capitalism in the U.S. and England.
• Keynesian aggregate demand remedies for the business cycle are just palliatives - just as they always were for 2500 years before Keynes. Budgetary deficits and monetary expansion can't address any of the fundamental problems involved in any particular economic decline - and indeed will make matters worse - sometimes much worse - if persisted in aggressively and in lieu of making needed reforms.
• Of course, palliatives can be useful if they gain time for reforms. This can occur for mild recessions caused mainly by private policy errors such as inventory buildup - private debt or capital asset or other bubbles - banking or other financial system failures - or widespread retention of outmoded facilities or obsolete or fraudulent business plans during prosperous times. But this is not the case for depressions or intractable inflations caused mainly by the accumulation of government policy blunders such as policies that increase costs or risks of commerce or enterprise - trade restraints - bloated government budgets - burdensome levels or types of taxes - monetary inflation - war and its financial impacts - failure to prevent lawlessness or anarchy or other physical threats to persons or property - burdensome laws or regulations - corruption - or failure to provide or maintain vital infrastructure. In such cases, reliance on Keynesian palliatives as a substitute for needed but politically inconvenient reforms - as in Japan and Argentina - will ultimately result in burdensome public debt levels and/or monetary collapse and stagflation or inflationary depression.
• Here, too, the dubious accuracy of economic statistics must be kept in mind.
• And, where are profits? Perhaps it was missed - but there is apparently not a single effort to include business profits or profit margins in any of Chow's macroeconomic econometric models. How can any model purport to represent a capitalist market economy without taking the obvious impacts of profits and profit margins into account? How can the real value of capital assets be estimated except in relation to profits and risk and reward ratios? Only someone foolish enough to fall for the various socialist and Marxist propaganda myths about capitalism could believe in the validity of a model of capitalist market systems that failed to highlight the vital roles played by profits in driving economic growth and the business cycle.

  Indeed, Chow perceptively acknowledges that this analysis is dependent on the validity of the underlying Keynesian theory - and wisely specifically leaves that question open. Wisely, he does not rely on econometrics for his analytical conclusions, so these econometric segments can be simply ignored without loss. Later in the book, he candidly concedes that:

  "Economists disagree on what the best [macroeconomic] policies are. They do not fully understand how the macro economy works, or they disagree on the objectives, how important price stability is compared with reducing unemployment."

  But here, Chow himself gives credence to a common theoretical fallacy - that there is a tradeoff between inflation and unemployment. (Except in the short run, inflation above de minimus levels always causes unemployment and undermines economic stability.)
 &

Monetary analysis:

&

  The relationship between China's monetary factors and price inflation, however, are much more appropriate subjects for mathematical reasoning due to the availability of monetary and pricing data. Although far from perfect, this data is sufficiently reliable for the purpose. 

  Of course, even here, the statistics have to be carefully evaluated. Real inflation in China as elsewhere is always higher than price inflation, since it also overcomes the price level declines that would otherwise occur due to increases in productive efficiency. For example, U.S. prices declined on average about 1.5% per year during every decade of the 19th century - the century when the U.S. became the wealthiest nation in the world - except for the 1850s and 1860s - the decades of the gold rush and the Civil War.

  The author also provides interesting analyses of the Chinese markets for housing and computers.
 &

The costs of Mao's policies:

&

  Chow uses econometric techniques to evaluate the long term damage caused by the two great economic disruptions initiated by Chairman Mao. The Great Leap Forward was far more disruptive than the Cultural Revolution. By one calculation, output and consumption would have been 2.7 times greater in 1992 but for these events. With more conservative methods, the figure falls to between 1.2 and 1.7 times greater.

  These are interesting exercises in mathematical reasoning and statistical evaluation, but the exact figures are really of no consequence and the wide range of results reveals the weaknesses of the models. Suffice it to say that the results of Mao's economic incompetence were vast. But democracies, too, can surrender to political expediency and initiate economic policies that cause vast economic losses with disastrous political consequences - as occurred during the Great Depression of the 1930s and the intransigent inflation of the 1970s.

About all the modest increase in per capita consumption prior to 1978 was due to the increase in labor participation rates, as women were brought into the labor force. This undoubtedly reduced the "nonmarket consumer goods and services" provided by housewives

  The author uses simulated growth rates - against which he compares the observed growth rates to estimate the long term losses caused by the two disruptions. It is revealing that his simulated growth rates are practically the same both before and after 1978.

  It is unlikely that Chow really believes that growth under central planning could have been as great as after the initiation of economic reform. Otherwise, why did they bother with reform?
&
  Most of the growth before 1978 went into capital stock - but this fails to evaluate how much of that capital was a waste. To get real growth rates, an analysis must use the real value of capital stock investments rather than simply the sums invested in capital stock - and this is impossible in the absence of profits gained in a competitive environment.
 &
  A steel mill built for a tariff protected market is a liability rather than an asset if it produces steel at higher than import costs. Subsidized  and/or tariff protected farms that similarly produce at higher than import prices are liabilities rather than assets.

  Chow, of course, recognizes that the economic expansion prior to 1978 suffered from "distortions" as a result of the planned industrialization and the insufficient emphasis on consumer goods and consumption. He points out that about all the modest increase in per capita consumption prior to 1978 was due to the increase in labor participation rates, as women were brought into the labor force. This undoubtedly reduced the "nonmarket consumer goods and services" provided by housewives (something else that no econometric model can accurately include).
 &  Moreover, he recognizes that farms produced "nonmarket goods" - gray market goods - for their rural residents, and in various ways increased the purchasing power of their money by selling produce locally  at below-market or official prices. These factors may reduce the perceived gap between rural and urban families - and impact the accuracy of consumption statistics.

  More than the vast majority of economists, Chow has a keen insight into the limitations of econometrics.

 Governance:

&

  The appropriate government role includes monetary and budgetary discipline, and limiting the impact of inevitable business cycle reverses. It includes major infrastructure projects - especially those involving monopoly services and/or benefits that are difficult to allocate. These include highways, railroads, power plants, water conservancy and flood control projects, environmental protection facilities, and communications networks. Nevertheless, he notes that some of this is being built by private entrepreneurs.
 &
  The government role includes basic education and other investments in human capital that should be widely available. It includes social insurance and welfare programs - although the author asserts the superiority of voucher systems that stimulate private competition as a remedy for the inherent weaknesses in government services. Chow includes health care and income inequality as appropriate government concerns.
 &

  Human capital and political stability are also among the prerequisites for economic development. Chow correctly points out that market incentives alone are not enough.
 &
  The competing strengths and weaknesses of autocratic and democratic market systems are discussed. He wonders whether autocratic governance is better for a market system.

  While demagogic impulses pervade democratic governance, one should not overlook their strengths. An effective electorate can force reform of an obstructionist bureaucracy - shine the light of publicity on corruption - and threaten excessive political bungling and favoritism with loss of incumbency. There is indeed still a direct relationship between the extent of autocratic power and the level of corruption. It remains to be seen how well autocratic China handles its corruption and bureaucracy problems.

• Township and village enterprise systems operating without clear property rights are a proven success.

  Compared to what? They are certainly far superior to SOEs under central planning. However, they have yet to compete with private enterprises on a level commercial and legal playing field.

• There is an appropriate role for government owned monopolies to compete in international markets. He believes that as long as the problem of management incentives can be solved and its operations are conducted in a competitive market, government ownership is not inconsistent with market principles. He correctly points out that the problem of appropriate management incentives exists in major private corporations, too.

  It is a fallacy derived from left wing propaganda that private ownership plays little role in the efficiency of large corporations. The notorious advocacy scholar John Kenneth Galbraith spent decades asserting this obvious absurdity.
 &
  Unfortunately, governments are always lousy owners. Cognizant officials are not putting their own assets at risk, and can and do draw on public funds and other assets to subsidize such government enterprises. Government owned enterprises are given favorable tax treatment and other benefits that impose greater burdens on private economic entities and the public. They are not permitted to fail.

• The SOE incentive problem can be solved if management is only rewarded for the success of the enterprise, and for hard work for the benefit of the enterprise, and if successful management is in fact well compensated. Management and cognizant bureaucrats must not be able to receive unearned "rents."

  This is not quite right. Management reward must be for effective work. How hard management works is not really relevant - although usually required for effectiveness.
 &
  Although clearly far from perfect, the only practicable method for evaluating the success of major enterprises comes from profitability from competitive performance and the buy and sell decisions of private investors. Dealing at all effectively with the corruption problems - with problems of  "unearned rents" - in the absence of a personally concerned ownership interest is probably an impossibility.
 &
  The right to fail ("creative destruction") is as important as the right to succeed in market economics. Government enterprises are not permitted to fail until they become sinkholes for vast resources - if even then.
 &
  Chow's prescription for state ownership would privatize profits on behalf of management and socialize losses - the classic prescription for "moral hazard." Only owners have their own assets at risk in an enterprise and thus have an interest in its long term prosperity. Milking assets rather than maintaining and renewing them, restricting research and development to increase immediate profitability - such practices are punished by lower p/e ratios for private corporations if properly revealed by financial reports. Ultimately - especially during periodic recessions - mismanaged private corporations decline and fail, facilitating the expansion of better managed competitors.