Xu Xiaonian, "Two China Models"

Xu Xiaonian, “Two China Models”[1]
 
Introduction and Translation by David Ownby
 
Introduction
 
Xu Xiaonian (b. 1953) is an economist known for his full-throated defense of the free market, and thus is associated with other Liberals like Wu Jianglian 吴敬琏 (b. 1930), Zhou Qiren 周其仁 (b. 1950), and Zhang Weiying 张维迎 (b. 1959).  He earned his Ph.D. in the United States and was an assistant professor at Amherst College before returning to China.  He worked in business, government, and academics over the course of his professional life (a brief CV is available here), and was Professor of Economics and Finance at the China Europe International Business School in Shanghai from 2004 to 2018.
 
The text translated here repeats the message Xu has repeated throughout much of his life:  free markets are good, government intervention is bad.  It is the same argument one finds in the pages of The Economist  or the Wall Street Journal, and it is an argument accepted by many Chinese intellectuals and entrepreneurs.  Xu originally wrote the piece for a graduate student conference held in Germany in 2015.  There is no explanation as to why it was posted to Aisixiang this month.  My suspicion is that it is a pushback against fears generated by central authorities current emphasis on “common prosperity” that such an initiative will hurt markets and entrepreneurship and possibly even lead to some kind of central planning.  Xu’s particular concerns are with over-investment and over-supply, particular in real estate, and he urges China to address such problems, abandon Keynesianism, and return to Adam Smith.  The property giant Evergrande’s current woes suggest that the problems have not been resolved since Xu first wrote this text six years ago, and some speculate that China’s economy might collapse like Japan’s did in the 1990s. For similar sentiments in other texts recently translated on this site see here and here. 

Links to other texts on the site

Texts related to liberalism
 
Translation
 
After nearly four decades of reform and opening, China has undergone huge changes and made many achievements in terms of economic development, and its long-term rapid economic growth has captured the attention of many. The year 2008 saw the outbreak of the global financial crisis, and in response to the impact of this financial turmoil, the Chinese government launched the "Four Trillion Yuan Stimulus Package" in 2009. With these unprecedented fiscal and credit inputs, China was not only the only bright spot during the worldwide recession, but also became the locomotive driving the world economy. In the eyes of Western observers, this "China model," which is different from India's free market economy as well as from Stalinist central planning, has created an incredible miracle. Over time, the China model rose to prominence as a model for economic development in the new century, and even Chinese people began to see themselves as the saviors of the world.
 
However, the "Four Trillion Yuan" plan to save the world has brought unintended consequences to China. In recent years, the world economic recovery has been strong, particularly in the United States, but China's economic growth has been sluggish, exposing a series of more serious problems.  The GDP growth rate fell, the real estate market declined, local governments are heavily indebted, and finally the shocking plunge of China’s stock market this year [2015] put the entire world into a cold sweat. 
　　
It is no exaggeration to say that China's economy has entered the most severe period since reform and opening, and the international evaluation of China's economy has made a rapid 180-degree turn. Whereas during the economic crisis international observers and commentators praised the China model and argued that the 21st century would be China's century, they now frown and worry about China’s being the biggest destabilizing factor in the world economy.
　　
We cannot help but ask: Why is the China model suddenly no longer working?  To answer this question, we have look deeper, and ask: What exactly is the China model?
　　
What is the China Model?
 
According to one very popular opinion, the core of the China model is "big government," that is, a very strong government, with an extraordinary ability to extract and mobilize resources, which means that it can do whatever it wants.  For example, in 2009, it said it could spend four trillion yuan, which is something I suspect no other government in the world could do. We can compare this with Berlin (where I was a visiting scholar at the time), which is the capital of one of the world's leading economic powers, but if Berlin wants to build a new airport, the voters’ mood decides whether to green light the project, and funding might disappear overnight, leading to rethinking and work stoppages, so that you never know when the airport will be built. How many airports will China have built while Berlin messes around? China’s high-speed railway network has already made it to the Qinghai-Tibet Plateau.
 
Is the core of the China model a strong government? If that's the case, the Chinese economy shouldn't be in trouble and the China model should be working just fine because the government is still strong, if not even stronger than it was in the past.
　　
I think this interpretation is inaccurate, as it ignores the history of China's reform and opening of the past four decades. In fact, China's economic reform consisted of two phases, one after the other, with what we call "big government" or "strong government" only emerging in the latter phase. In the earlier phase, from 1978 to the mid- to late-1990s, we saw exactly the opposite:  a progressive retreat of the government and a continuous development and growth of private forces 民间力量, not a "big government" but a "small government" in which the state retreated and the people advanced 国退民进.  With this "small government" model, China also achieved double-digit annual economic growth.
　　
If a China model exists, then there are two, rather than one, representing different paths to economic growth. The first path drives economic growth by increasing the efficiency of resource use, which we can call the "Adam Smith model," referring to a certain school in the history of economic thought. The second path seeks to drive economic growth by increasing resource inputs, which we can call the "Keynesian model." From this perspective, we will first review the history of reform to seek out the true driving force of the economic take-off in the first stage; and then subsequently analyze our current economic situation to find the crux of the problem and the means to solve it.
　　
Stage One—the Adam Smith Model
 
If you ask where China's reform and opening began, most people will probably cite the 1978 responsibility system created in Xiaogang Village, Fengyang, Anhui Province. In that year, 18 villagers signed a "life or death contract," a huge risk  in the political climate of the time, contracting the land of the People's Commune out to households (or groups). What is the advantage of this model of contracting out to households and sharing profits and losses, compared with the former model of collective labor and distribution by work share?  In the language of economics, the latter model lacks clear property rights and profit attribution, which will produce the "free-rider phenomenon," in which some people do not work hard, because the outcome is the same whether you work or not. The economics of the responsibility system is that it solves the incentive problem based on clear profit attribution.
　　
Different systems produce different incentives. When I was sent down to the rural areas of northern Shaanxi during the era of the people's communes, I could see at a glance which fields belonged to the production team what which were farmed individually when I climbed up the mountain every day to go to work.  The crops on public land were a mixture green and yellow, but the crops on private land were green and thriving, and the contrast was very strong. This is the "tragedy of the commons,” as we say in economics.

The responsibility system was a huge motivation in terms of peasant labor, and the face of the countryside was renewed, even though land and labor did not increase and agricultural production techniques stayed more or less the same.  The change rapidly solved the problem of food supply that had plagued China's cities and towns for years. Stores were full of a rich variety of agricultural products in sufficient quantities, and the ration coupons everyone had used for years became antiques.  The era of limited consumption by urban residents was gone for good.
 
It is worth mentioning that the reform of the rural land system, the starting point of China's reform and opening, was a spontaneous act by the private sector, without government design or guidance. This is certainly not to say that the government did nothing, but in this case the role of the government was to not interfere, to not suppress the initiative, but instead to affirm it, put it in context and promote it, and ultimately to endorse the responsibility system so that it became national law and policy.  In 1999, the National People's Congress wrote the "responsibility system" of the villagers of Xiaogang Village into the constitution as a system of joint family responsibility contracting for farmers, and it has been the basic state policy since then.
　　
The effect of the responsibility system was not only to unleash the huge productive capacity of rural China, and its impact went far beyond rural and agricultural areas. People soon discovered that increased production incentives and productivity solved the long-standing problem of rural labor shortage, and rural labor shifted from a state of scarcity to one of surplus, which created the conditions for industrialization in the towns and cities. As reforms moved from the countryside to the cities and the private establishment and operation of enterprises became legal, newly opened collective and private factories were in urgent need of labor, and idle rural laborers entered the cities and towns in search of work. This illustrates that the significance of rural reform cannot be overestimated, as China's industrialization and urbanization would not have been possible without agricultural reform.
　　
As industrialization began, China entered a period of economic takeoff, as evidenced by years of sustained high GDP growth. However, it should be noted that this high growth is not a Chinese characteristic and should not be seen as a phenomenon unique to the "China model". Extraordinary economic growth rates are a universal phenomenon in the world history of industrialization.  For example, Germany, which was industrializing in the second half of the 19th century, had the highest economic growth rates in the world for a long time, and its economic volume surpassed that of Britain and France before World War I, becoming the second largest economy in the world after the United States. Japan also achieved rapid economic growth during the industrialization that began after the Meiji Restoration, and it was with the economic strength accumulated during this period that Japan launched its invasion of China and its subsequent war against the United States. As an aside, German and Japanese industrialization led both of them to the position of second largest economy in the world, and they challenged the hegemony of the United Kingdom and the United States, respectively, and wound up losing in war. Can the world's second largest economy avoid the "second-best dilemma" and pass through this stage successfully? We need to learn the lessons of history.
　　
There is nothing mysterious about China’s economic growth from 1978 to the late 1990s; the main reasons were the industrialization and urbanization initiated by reform and opening, the reallocation of resources from inefficient agriculture to efficient industry and commerce, and new incentives to increase the productivity of land, capital, and labor.
　　
If China's industrialization was different from that of other countries in history, it was in the privatization that followed industrialization. The abolition of central planning provided an additional impetus to economic growth by allowing resources to flow not only from inefficient agriculture to efficient industry and commerce, but also from the inefficient state-owned sector to the efficient private sector. Privatization played a less significant role in the industrialization of countries such as Germany and Japan, where the economy was already predominantly private prior to industrialization. Some people argue that state-owned enterprises (SOEs) are not necessarily less efficient, and some are even profitable, but this is because of the financial subsidies and low-interest loans provided by the state, as well as the almost free access to land and minerals, and the administrative protection afforded to markets and monopoly pricing. If we deduct the effect of these preferences, we have seen empirical studies where SOEs have a negative return on assets. Why are private enterprises more efficient than SOEs? The reasoning is still the same as that of the responsibility system, that there is a difference in incentives, and people are more careful with their own assets than with those of others, and always attempt to increase the value of those assets.
　　
Another layer of efficiency improvement brought about by privatization is that the coordination of socio-economic activities has changed from government directives to the guidance of market price signals, from the "visible hand" to the "invisible hand.” The "invisible hand" is more efficient than the "visible hand" for the reason that Smith identified:  if the price of a product rises, it means that the supply exceeds the demand, and enterprises take the initiative to produce this product to meet the market demand in order to earn more profits and satisfy the needs of the market.  Supply and demand function without the government’s direction. In a planned economy, there is no price signal, which means that the government does not know which “command” to give, because it does not know where the gap between supply and demand is, or how big it is, let alone which enterprise should produce what. Prices in a market economy mobilize the enthusiasm of enterprises to bring together the private interest in making money and the public interest in meeting the needs of society, of self-interest and altruism.  As Smith himself said: I can eat a delicious breakfast today, not because my cook loves me, but because he loves himself.  He likes his job, and in order to keep it, he pleases me and works hard to make me a good breakfast.
　　
So to summarize, during the first two decades of reform and opening, China's rapid economic growth was driven not by a policy of investment, but by market mechanisms and private dynamism, not by an increase in the quantity of resource inputs, but by an increase in the efficiency of resource allocation and use. Of course, the role of the market and the private sector presupposes that the government gives enough space for them to function, by abolishing people's communes, legalizing private enterprises, and so on. The role of the government in the economy is not to replace the market and dominate economic activities, but to break the shackles of the old system on the economy, adjust policies and amend laws to meet the needs of market development, reduce regulations, and allow the free play of private creativity and market mechanisms.

The Latter Period—the Keynesian Model
　
Around the mid-to-late 1990s, the pattern of economic growth quietly changed, and a landmark trend was the shift away from declining to rising government revenues as a share of GDP. Because of the fiscal constraints on the central government, the government carried out fiscal and taxation reforms in 1993 and 1994, which changed the pattern of small central government and large local government, and the total fiscal revenue of all levels of government increased significantly, gaining enough financial power to influence the national economy. The ratio of fiscal revenue to GDP declined between 1978 and 1993 while China followed the Smith model, which can be described as a phase in which the state retreated, making room for the people; this ratio gradually increased from the mid to late 1990s, shifting to the "Keynesian model," in which the state intervenes and the people retreat.
　　
There are reasons for this shift in models, the most fundamental of which is the stagnation of the reforms. Smith's model called for sustained institutional innovation, like that of the responsibility system, to keep breaking out of the old planned system and unleash the energy of the market and the private sector. By the mid-to-late 1990s, however, institutional reforms were largely invisible, and economic growth lost momentum. What to do? My impression is that the popularity of Keynesian economics began at about that time, and with its emphasis on fiscal spending, the central bank’s printing money, and short-term results, this economic theory and policy is particularly suitable for the needs of the government.
　　
When the financial crisis broke out in Asia in 1997, the Chinese government launched its first proactive fiscal policy, officially opening the era of Keynesianism, and since then, the government's intervention in the economy has become increasingly broad and deep. In the face of the financial crisis that swept the world in 2008, in order to compensate for the decline in external demand, the government introduced the "Four Trillion Yuan" stimulus plan, a two-pronged approach to fiscal and monetary policy, with more than tens of trillions of yuan in capital investments. Following the impact of this unprecedented policy, the economic downtrend was curbed and a strong V-shaped rebound was achieved. Unfortunately, the good times did not last, the policy boom lasted only two or three quarters, after which the economy re-entered a downward slide. This time the policy boom was even shorter, and economic growth declined again in 2013.
　　
With the shift from the Adam Smith model to the Keynesian model, the "invisible hand" of the market has been greatly reduced, and economic growth is increasingly dependent on the "visible hand" of the government, and Keynesianism has become popular in academia, politics, and the private sector. Because stimulus policies such as the "Four Trillion Yuan" plan seemed so effective in the short term, and because China's economic performance was so impressive compared to other countries, many Western scholars defined and discussed the China model in terms of big government and extensive intervention.
　　
Like opium, Keynesian policies stimulate short-term demand but fail to achieve sustainable growth in the long run.  In addition, bailout measures are used repeatedly and hence are gradually routinized, feeding the dependence on opium. Policy inputs cannot drive economic growth in the long term, because no matter how strong the government is, its resource investment capacity is limited, not can it endlessly borrow money or printed unlimited amounts of currency.  Second, even if the government can continue to invest, sooner or later it will hit an invisible wall, what economists the "law of diminishing marginal returns to capital."  In other words, the more capital is invested, the lower the rate of return, and when the return on investment drops to zero, reinvestment can no longer stimulate the economy. Data show that since the "four trillion" stimulus plan, the amount of GDP produced by each yuan of investment is indeed declining year by year, from more than 20 cents in 2009 down to just a few cents in 2014.
　　
The result of over-investment is excess capacity in various industries, especially in manufacturing, where supply capacity exceeds the purchasing power of society and supply exceeds demand, forcing enterprises to continuously reduce prices; but on the other hand, costs become rigidity, especially labor costs. Enterprises are squeezed by both prices and costs, and operating margins are reduced, becoming losses, and if losses continue over a long period, ultimately the only choice is to reduce or even stop production. At present, if we visit the enterprise-rich regions like the Pearl River Delta and Yangtze River Delta, we see many enterprises that are closed or even bankrupt. So from an economics perspective, government investment can achieve results in the short term, but after a certain period of time it will create excess capacity, and business efficiency will follow prices and decline, meaning that Keynesian model is unsustainable.

Another legacy of Keynesianism is high government indebtedness, because where do you get the money for tens of trillions of yuan of capital investment? The answer lies in the "land finance" that emerged around 2008. There are two ways to raise money through land finance.  The first is requisitioning and then selling land.  The government buys land from farmers at a very low price and sells it at a high price in the market, and the difference is the government's income. The second method is to use the land as collateral and have various government development companies borrow from the banks. In a situation where land finance accounts for an increasing proportion of local government revenue, it is easy to understand why the demands from society for lower housing prices continue to increase, and why the state shies away from genuine regulation of the real estate market.  They make occasional efforts to tamp down prices, but the stronger pull is to let them rise, because once the real estate market fizzles, there is a real danger of local finances drying up.
　　
At this point, we can see three main risks to the Chinese economy, risks accumulated from years of implementing Keynesian policies. First, land is limited, and the more available land resources you sell the less remains, land finance is unsustainable, and the bill is due for past loans, so that local government debt is a major risk point for the Chinese economy. Second, if the government can't repay its debts, banks are stuck with ever more underperforming loans, which means that the quality of bank assets will deteriorate and their normal credit function will be affected, which will have an impact on the economy as a whole. Third, a large amount of land and capital is invested in the real estate market, which is over developed, so that now there is a widespread oversupply of real estate, except in places such as the Beijing, Shanghai, Guangzhou, and Shenzhen. Once the real estate market bubble bursts, not only will local government finances be in trouble, real estate developers will also have difficulty selling properties and repaying their debts, and may well default on their loans, further increasing the banks’ non-performing assets.
　　
The three risks mentioned above closely linked, and all have their source in the Keynesian growth model. Without a fundamental shift in the economic growth model, all three risks will be difficult to resolve.
 
Conclusion
　
China's economy is now entering a difficult period, and before thinking about solutions, we need to have a clear understanding of the harsh reality of China's economy. We don't have to be pessimistic, nor should we underestimate the potential of China's economic growth. The crisis is not to be feared, if we can turn it into an opportunity for reform. When things are going well, people live it up and do not think about reform, and it is only when times are hard that consensus on the need for reform finally comes together, which brings us closer to an exit from the crisis and puts us on the path of new economic growth. From this perspective, a recession may not be a bad thing.

For the economy to recover, all the risks accumulated over the years of following the Keynesian model must first be dealt with, which may take awhile. Once we have taken care of the debt, excess capacity, and bad bank loans, we need to return to the China model of the first half of the reform and opening period, i.e., the Adam Smith model. Some people outside of China think that the China model is all about big government and strong intervention, which is a misconception. They do not understand how China’s economic reforms have developed, what kind of changes have happened along the way, nor do they understand the relationship between Smith's model and economic growth, and they have unthinkingly slapped a Keynesian label onto China's economic reality.
　　
We need to think independently, understand the history of reform, analyze in depth the reasons for past successes and the root causes of current difficulties, and find solutions. As someone who participated in the reforms and as a researcher, I have witnessed and personally experienced the tremendous changes brought about by the reforms, and believe that as long as we firmly promote market-oriented reforms, it is entirely to be expected that China's economy will return to prosperity.
　　
Notes

[1]许小年, “两个中国模式” originally written for a Graduate Student Conference in Germany in 2015, posted on Aisixiang on November 18, 2021.