The Great Economists Page 8

  The end of the nineteenth century was when Marx finally saw his communist theories in action. The last quarter of the 1800s saw frequent recessions coupled with deflation or falling prices. It has been dubbed the Long Depression or the Great Depression of the nineteenth century. In the 1870s, economic crises plagued Europe and North America. Stock market crashes led to deep recessions, which generated high unemployment, labour unrest and strikes. During the Long Depression, nineteen socialist and labour parties were founded in Europe as well as trade federations. So, the downsides of industrialization paved the way for the workers’ movement that appeared not only in Europe but also elsewhere in the world.

  That was also the period during which Marx’s ideas took hold in Russia. Russian was the first language into which Capital was translated. One reader was Vladimir Ilich Ulyanov. Although he had never met Marx, Ulyanov helped organize Marxist groups to create the ‘St Petersburg League of Struggle for the Emancipation of the Working Class’ in 1895. After being jailed and exiled to Siberia for several years, Ulyanov left for western Europe in 1900 to continue his revolutionary efforts and adopted the pseudonym Lenin. In 1903 Lenin met other exiled Russian Marxists in London and established the Bolshevik Party, which differed from socialist parties in that its members advocated revolution to achieve their aims. When the Russian Revolution against Tsar Nicholas II erupted in 1905, Lenin returned home. More than a decade of political unrest followed until 1917, when Lenin seized power. Russia then became the Soviet Union or Union of Soviet Socialist Republics (USSR) in 1922 after Lenin consolidated his position. The Soviet Union was the first Marxist state in what Lenin intended to be a Marxist world.

  Lenin’s Soviet Union may have been the most prominent adopter of Marxism, but Mao Zedong’s China was the most populous. After winning a civil war against the US-supported Kuomintang (the Chinese Nationalist Party led by Chiang Kai-shek), Mao’s Soviet-backed Communist Party adopted a communist system in 1949, more than half a century after Marx’s death. A falling out with the Soviet Union in the 1950s, though, saw China split from Leninist thought and adopt Maoist doctrines.

  Although the Soviet Union had disintegrated by the early 1990s, and Mao’s extremist ideas are long gone, China is still run by the Chinese Communist Party. To think about Marx in today’s world, we would most usefully look at China, which adapted Marxism into its own form of communism that governs the world’s second largest economy.

  But China’s evolution towards becoming a market-based economy is not what Marx would have envisaged. Unlike Russia, which abandoned communism for democratization alongside the transition to a capitalist system, China retains elements of Marxist thought, including state ownership in key sectors, alongside significant marketization.

  China’s adoption of market-oriented reforms in 1979 was due to substantial challenges that arose in its centrally planned economy, which had followed communist principles. Economic decline led to the abandonment of a command economy after three decades. It was followed by nearly forty years of remarkable growth that propelled it to rank behind only the US in terms of the size of its economy. To sustain growth for the coming years, China has now embarked on another ambitious set of reforms to join the ranks of rich countries. Average income in China today is still only one-sixth of the US level.

  What would Karl Marx make of it all? Is it possible for a communist state to become rich?

  China’s economic transformation

  China has accomplished a remarkable feat in transforming itself from one of the poorest countries in the world into the second largest economy in under four decades. The economy has expanded at an average rate of over 9 per cent per year since market-oriented reforms began in 1979. Chinese statistics aren’t the most reliable, but household surveys and others indicate that China has not only doubled its GDP or national output as well as national income every eight years or so, but also lifted hundreds of millions of its citizens out of abject poverty. In the world’s most populous nation, with 1.3 billion people or one-fifth of humanity, the World Bank estimates that the country is on its way to ending extreme poverty, in which individuals live on less than $1.90 per day.

  China is unusual in that, while it is transitioning from a planned economy that has dismantled many of its state-owned enterprises and banks, it is simultaneously a developing country in which half the population still live in rural areas. China is also an ‘open economy’ integrated with world markets.

  China remains a communist state governed by the Chinese Communist Party. It’s therefore unsurprising that the rule of law and other market-supporting institutions, such as private property protection, are weak, as there is no independent judiciary. This gives rise to the so-called ‘China paradox’, because the country has grown strongly despite not having a well-developed set of institutions. China’s economic growth is, therefore, in many respects both impressive and puzzling. It is also, as with other fast-growing economies, not guaranteed in the long term.

  An example of China’s particular model of growth can be seen in the differences from other developing countries when it started to reform. Unlike them, China was industrialized early on, during the command economy period between 1949 and 1979. China followed Soviet-style industrialization plans in the 1950s and 60s that focused on transforming an agrarian society into an industrialized economy. China’s centrally planned system established state-owned enterprises that created industries where none existed before. Since market-oriented reforms were introduced in the late 1970s, China has undergone a reindustrialization process of upgrading obsolete (state-owned) plants and premises into more advanced (largely privately owned) machines and factories. As Adam Smith well knew, industrialization propels faster growth, so China was able to grow faster than most developing nations struggling to industrialize over the past few decades. Industrialization is accompanied by investment in factories, R&D and so on, which gives a further strong boost to growth. Adding capital accumulated from years of investment has accounted for about half of China’s economic growth since market-oriented reforms began. In other words, its success can be explained by the standard economic factors such as investment, but with additional features, notably the reindustrialization of what was then a lower-middle-income country, that are specific to its unusual context.

  Another example of China’s particular growth model is that productivity is also driven by ‘factor reallocation’, for example labour migrating from less efficient state-owned industries to the more productive private sector. The process of factor reallocation is contained within the industrial sector, so it is not captured by the urbanization and industrialization processes which usually explain how developing countries grow by moving workers from rural and agricultural sectors to urban and manufacturing work.

  Moreover, China confounds any straightforward interpretation of the theories that link ‘openness’ to the global economy with economic growth. These explanations centre on the positive correlation between greater opening and faster development, as expounded by David Ricardo. Economies open to the global economy grow quickly because the experience of exporting and accessing global markets can lead to improvements in competitiveness. Domestic firms can also ‘learn’ from foreign investors with more advanced technology and managerial know-how. ‘Openness’ allows a developing country like China to ‘catch up’ in its growth rate if it can imitate the existing technology embodied in foreign capital and thus grow more quickly, and perhaps even eventually attain the standards of living of advanced economies.16

  China is open to the global economy, but exercises elements of control that have prevented direct competition from foreign companies in its economy in a number of sectors. It utilizes a policy towards foreign direct investment (FDI) that furthers its own active industrial policies to develop domestic companies and launch them globally as Chinese multinational corporations. As such, the simple openness measures do not fully capture the nature of China’s ‘open door’ policy that introduced market-oriented
reforms in the external sector first in 1979, which then accelerated after 1992 and culminated in its joining the World Trade Organization in 2001.

  Several metrics are needed to calibrate the influence on growth of opening up the economy to international trade. For instance, at the start of the reform period, when China was a poor country with a low rate of household saving that was only 10 per cent of GDP, foreign investment supplemented domestic investment, accounting for as much as one-third of the total. Since then, household savings have been as high as 50 per cent of GDP, which is arguably too high as the money has been used to fund investments that are not always productive, such as the ‘ghost cities’ where residential housing is built but not occupied. Foreign direct investment that established Chinese–foreign joint ventures and other foreign-invested enterprises were explicitly geared towards exports and prevented from selling into the domestic market, which protected Chinese industries from foreign competition. They were initially located in Special Economic Zones, which were created as export-processing zones similar to its East Asian neighbours. China thus became integrated with East Asia, as it joined regional and global production chains, and eventually became the world’s largest trader. Undoubtedly, foreign investment and export-orientation benefited its economic growth, but China’s policies defy easy categorization as they have always been uniquely tailored to the country’s circumstances.

  By the late 2000s China was contributing to the ‘global macroeconomic imbalances’, where the countries with significant trade surpluses (China, Asia and the Middle East oil exporters) saw their surpluses grow while the United States experienced larger trade deficits. The global imbalances and other aspects of the ‘China effect’ (or ‘China price’ whereby cheap Chinese labour has pushed down global prices for manufactured goods) point to the need to examine China as a large, open economy. In other words, it is similar to the United States in that what China does affects the world economy in a way that most countries do not. So openness has undoubtedly contributed to China’s economic growth but in a nuanced manner.

  The other part of technological progress needed for economic growth derives from domestic innovation, and not just reliance on foreign technology. Coming up with innovative technologies requires researchers and R&D investment. China has increased its focus on patents and investment in R&D since the mid-1990s in an effort to support economic growth. Although Chinese researchers and scientific personnel are numerous, the evidence regarding how advanced Chinese innovations are remains mixed. Yet this is the crucial area for sustaining China’s growth and for it to become a rich nation. Protecting intellectual property is also a concern, exacerbated by China’s lack of an effective rule of law, though the situation is improving.

  Indeed, one of the most complex areas of Chinese growth is the role of legal institutions. The predominant view is that market-supporting institutions, such as those which protect property rights and provide contracting security, are important for growth. China has been considered paradoxical in having a weak legal system but strong economic growth. However, China as an ‘outlier’ requires a closer examination as to how markets were enabled, given the poor formal legal system. Specifically, the reliance on relational contracting, so transacting with those whom you trust, can help to reduce dependence on the judicial system which is being gradually improved as more Chinese firms clamour for better protection of their inventions. The institutional theories that deem a good legal system important for growth therefore apply to China, but there are again nuances to take into account.

  The role of informal institutions such as social capital also cannot be overlooked. Entrepreneurs in China relied on social networks, known as guanxi, to overcome the lack of well-developed legal and financial systems. It is also the case that the cultural proclivity towards interpersonal relationships meant that social capital played a key part in facilitating the development of self-employment and the impressive emergence of the private sector. That China would allow entrepreneurs to emerge within a communist system is, perhaps, not something that Marx would have anticipated.

  After reaching ‘middle-income status’ in the early 2000s, China found that it also needed to rebalance its economy to grow in a more sustainable manner. Its ability to overcome the ‘middle-income country trap’, whereby countries start to slow after reaching upper middle-income levels and never become rich, depends on it.17 Poor countries tend to grow through exports and cheap manufacturing. Growth in a middle-income country is driven more by consumption by its own middle class, leading to a diversified economy that is not heavily reliant on exports to consumers in other countries. For China, rebalancing the economy away from old growth drivers will involve boosting domestic demand (consumption, investment in more productive sectors, government spending that provides social services) so that it grows more quickly than exports. China has also shifted towards services so that the ‘factory of the world’ now has a bigger services sector than manufacturing. China is still upgrading manufacturing, expanding overseas investment and opening up its financial sector further. China is also promoting the internationalization or global use of its currency, the renminbi or RMB. To achieve these aims will also require examining the institutional framework of the economy, including the role of state-owned enterprises and the legal system. The retention of large state-owned firms and the problematic lack of a ‘level playing field’ for both foreign and domestic private firms vis-à-vis state-controlled companies raise doubts as to the efficiency of China’s markets and thus its ability to grow. So, for China to realize its economic potential will require a significant transformation of the structure of its economy.

  There’s also the issue of financial stability. An economic crisis, depending on the causes, could trigger a long-lasting downturn. Marx would view this as inevitable in a capitalist economy, of course. In China’s case, a financial crisis linked to too much debt or some other issue in its banking system would not be surprising. All major economies experience crisis eventually. Estimates of total Chinese debt by the Bank for International Settlements and others place it around 260 per cent of GDP, which is similar to Europe and the United States. But a key difference is the large amount of corporate debt in China, which is more worrying than government debt if there is a risk of large-scale bankruptcies that could bring down the banking system. And part of that debt is owed to the shadow banking system, where lending is done outside of the formal banks. It’s a murky sector which includes anyone who lends money without a banking licence, including loan sharks but also others. By definition, shadow banking debt isn’t measured accurately, so the overall level of Chinese debt is a source of concern.

  The growth of shadow banking is linked to the Chinese government not introducing sufficient competition into the state-owned banking system. A rapidly growing economy, powered increasingly by private entrepreneurs, requires credit. As private firms sought funds that the formal banking system, which predominantly lent to state-owned firms, were reluctant to provide, unlicensed lending grew. Shadow banking took off after the 2008 financial crisis in the West. As Chinese exports were hit by recession in America and the EU, growth was affected and so the Chinese government encouraged private companies to grow. Some did that by borrowing from shadow banks. Local governments also tried to boost their economies by investing in infrastructure projects, so they too borrowed. They followed the dictates of the central government, which planned for a large fiscal stimulus that relied on localities to find the money and spend it. Because China doesn’t have a well-established bond market where local governments can issue debt and borrow to fund their spending, some of them, too, turned to the shadow banking system.

  Since the end of the 2009 Great Recession in the West, the Chinese government has been clamping down on shadow banking. China recognizes the dangers of a debt crisis, like the one experienced by Japan in the early 1990s, that could derail its growth for years. A similarity that China shares with Japan is that nearly all of its debt is domestically h
eld. So, a financial crisis there wouldn’t necessarily spread far beyond the Chinese border, though there would clearly be a significant impact if the world’s second biggest economy were to suffer from a financial crisis severe enough to lead to economic stagnation.

  In order to stop borrowers from turning to shadow banking, the government has tried to develop other instruments to allow companies and local governments to borrow, such as building up the bond markets (the market for corporate and government debt). As in other major economies, that would allow companies and local governments to issue bonds or debt and borrow from capital markets rather than shadow banks to fund their growth. Also, if the Chinese banking system was not predominately state-owned, and there was greater competition due to new bank entrants, this would provide another alternative to shadow banking. Reforming the state-owned banks that dominate China’s financial system has been ongoing, but progress is slow owing to the powerful vested interests that benefit from running state-owned banks. This is an example where the communal property system hampers the growth of the increasingly marketized economy, and yet reform is difficult in a communist regime.

  So, to sustain China’s economic growth will require a series of reforms. Some of the challenges that the country faces are related to its communist political system and the retention of state ownership. Can they be overcome? Can a communist state become rich?

  Marx and China

  China’s revolution seemed to fit Marx’s paradigm. China’s communist revolt in 1949 was led by rural peasants, which differed from the proletarian revolution in 1917 in the USSR. Even though he lived in the world’s largest city after 1849, Marx became eventually convinced of the significance of agriculture in a capitalist economy and of the importance of social conflict in the countryside for revolution. In part, he gained these views from the French Physiocrats, David Ricardo and Thomas Malthus, all of whom considered the agricultural sector to be an essential part of the development process, and thus a source of capitalist conflict in Marx’s view. In Capital, Marx wrote of the labourers, capitalists, and landowners. Yet in the Communist Manifesto, written nineteen years before, he focused on two classes in a capitalist society: the bourgeoisie and the proletariat.