Recommended article by John Ross, ‘Why private companies grow fast in socialist China’

A striking feature of China’s economic development is the breadth of social layers benefitting from it. At the bottom of the economic ladder, China has lifted over 600 million people from internationally defined poverty – accounting for the entire global fall in the number of those living in poverty. Taking middle incomes, while median U.S. wages have fallen in the last seven years, China’s real urban incomes rose annually by not far short of double digit figures. At the top income level Alibaba’s IPO, raising US$25 billion, the largest for any company in history, turned Ma Yun into China’s richest person.

But Alibaba is the tip of an iceberg. By 2012, China had 10.9 million private companies, employing 113 million people, plus 40.6 million individual enterprises, employing 86.3 million people. No equivalently rapid expansion of private enterprises has taken place in any other country. How, therefore, has socialist China produced not only the world’s biggest improvement in living standards for ordinary, and the poorest, people but also the world’s fastest development of private companies?

The reason is that China’s economic structure successfully aligns all major economic forces. This is strikingly unlike the current situation in the G7 – which was characterised by IMF Managing Director Christine Lagarde economically as “the new mediocre” and Pew International Research polling found the prevailing mood as “pessimism is pervasive.” As the contrast, the continued rapid development by China’s private companies demonstrates the advantages of China’s economic structure, which has major lessons globally.

Taking first the West, the G7 proclaim themselves “market economies,” in which large numbers of private companies compete equally to produce fair and efficient economic outcomes. Small and medium private enterprises are held up as their economic exemplar.

But this image of economies dominated by relatively small scale production, with perfectly competitive markets, is a myth. A dominant feature of modern economies is increasingly large scale production. In a number of sectors the investments required are so large they produce pure monopolies – railways, the electricity grid, metro systems in modern cities etc.

Even when a pure monopoly does not exist, globalization illustrates the way that many branches of modern industry require production on an extremely large scale to be competitive – therefore it cannot be carried out purely nationally. The world only has two major civil aircraft manufacturers, less than 10 companies dominate world automobile production etc.

In its most developed form this creates companies recognized as “too big to fail” – firms operating on such large scales that no alternative can take over their functions without dangerously destabilizing the entire economy. This is explicit in sectors such as banking but, as the state bailout of the U.S. auto companies after 2008 illustrated, it extends to far wider ranges of industries.

Some economic sectors, naturally, remain characterized by competition between large numbers of companies – in tourism, one of the world’s largest industries, no company holds even a 1 percent market share. But overall, large companies dominate. The turnover of the world’s 2,000 largest publicly listed companies is equivalent to more than 50 percent of world GDP.

The ideology put forward in the West that a modern economy consists of huge numbers of small scale competing enterprises is therefore myth. Equally, the West treating a totally differentiated economic structure as though it were a single “market” has dangerously negative consequences – which actually inhibits development by private companies.

A key example is the financial system, which has been the core of economic crisis in G7 economies. The largest private banks being “too big to fail” necessarily incentivizes extreme risk taking, even criminal, activity. In a pure competitive economy, company risk taking is constrained by the threat of bankruptcy, but once a private financial institution receives a state guarantee as “too big to fail,” pursuit of the highest potential return, and consequently the riskiest financial projects, becomes rational – the private institution receives the profit if such projects are successful but the state absorbs the losses if they fail. The continuous series of private banking scandals such as LIBOR, JP Morgan’s “Whale” trading, and foreign exchange manipulation, are therefore inevitable, as was the huge asset misallocation seen in developments such as the U.S. sub-prime mortgage crisis prior to 2008.

Far from being a single “market,” a modern economy has at least three major types of market – pure monopoly, competition between small numbers of very large companies (oligopoly), and competition between very large numbers of small producers (perfect competition). An undifferentiated economic policy therefore cannot be successfully applied across economic sectors which have totally different economic structures.

China’s economic structure – “socialism with Chinese characteristics,” sharply differs. The very word “socialism” derives from “socialized,” i.e. large scale production. In China the purest form of large scale production, monopolies, are state owned. But, simultaneously, since 1978 China has rejected a distorted idea, originating in the USSR, that small scale, i.e. non-socialized, production should be in state hands. China’s agriculture is not collectivized, and purely competitive industries are left to private companies. In competitive sectors dominated by large scale production both state and private producers have advantages, so the best way to test their relative strengths is to let them compete – as China does.

This structure explains why China, a socialist country, has the world’s most rapidly growing private sector. China affirms the dominance of its state sector, but whereas in the West state and private companies are seen as counterposed, in China, for the structural reasons given, they are seen as complementary.

The economic structure of China has produced the greatest economic growth in world history. As Nicholas Lardy, one of the chief U.S. writers on China’s economy, recently summarized: “China’s growth since economic reform began in the late 1970s is unprecedented in global economic history. No other country has grown as rapidly for as long.”

China’s economic structure reinforces the world’s most dynamic private sector. While the state should not own companies in sectors dominated by small scale competition, and in China it does not, this does not mean such companies do not require the state. Economic theory shows an efficient competitive market requires preconditions – perfect knowledge of market conditions, simultaneous price adjustments, and minimal or zero transport costs. But these require real material underpinnings to be realized, and a lot of “infrastructure” is actually structures required for efficiently functioning competitive markets such as transport, information technology standards and structures, and wholesale markets. Frequently, due to their high costs, these are monopolistic and consequently best supplied by the state. Therefore, even in sectors where the state should not own the operating companies, the state is required to create the conditions for effective market functioning.

The same applies where research requires huge expenditures. To take a graphic example, it is a myth that the foundations of the information technology revolution, the cutting edge of U.S. industrial innovation, were developed privately. They were created by the U.S. state. As Martin Wolf, chief economics commentator of the Financial Times, wrote in a review of Mariana Mazzucato’s “The Entrepreneurial State:”

“All the technologies which make the iPhone ‘smart’ are… state-funded … the Internet, wireless networks, the global positioning system, microelectronics, touch screen displays and the latest voice-activated Siri personal assistant. Apple put this together, brilliantly. But it was gathering the fruit of seven decades of state-supported innovation.”

Regarding financing of private companies, in China, the state monopoly of large scale banks reduces the cost of capital for productive companies. In the West, high risk strategies, rational for “too big to fail” private banks, mean their assets are deployed in areas offering the highest returns and which therefore typically have the highest risk – derivatives trading, interest rate arbitrage etc. These can be undertaken on a large scale because fatal losses will be borne by tax payers. This has the effect of concentrating profits into the private financial sector. To attract savings for extremely profitable high risk activities, high deposit interest rates can be offered. Due to such pressure interest rates for supply of capital to productive companies is sharply raised. China in contrast, by controlling interest rates and restrictions on high profit but high risk financial operations, ensures a lower cost of capital for productive companies.

By providing both a cheaper supply of capital, plus a superior infrastructure, China’s economy creates particularly favourable conditions for the development of productive private business. By seeing state and private sectors as complimentary, China produced economic growth never achieved by Western economies. It is also why socialist China has the world’s most dynamic private sector.

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This article originally appeared on China.org.cn.

The author is Senior Fellow at Chongyang Institute for Financial Studies, Renmin University of China.



Categories: China growth, Econonomics

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