The Great Escape explained

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Can extreme poverty ever be eradicated? | The Economist didn’t mention spread of capitalism, globalisation and deregulation

Why the Chinese growth rate will taper down

Many years ago, Mancur Olson wrote an insightful book about prosperity and dictatorships. He introduced the concept of rights intensive production. As countries become more and more developed, investment horizons lengthen and depends more and more upon the enforcement of contract and property rights in a tolerably honest way.

Instead of being the first entrepreneur to introduce the most basic technologies and profit handsomely, such as in China with the advent of capitalism, entrepreneurs are introducing a product upgrade or new product that is a minor improvement on current offerings. Such investments will take time to pay off.

Many years ago, an article was published in the Journal of Economic Perspectives about a survey of entrepreneurs in Russia and Poland. It was in the early 1990s. Each was asked whether an investment project that doubled their money in two years was worth the risk. The Russian entrepreneurs mostly said no, the Polish entrepreneur said yes. So insecure are the returns from investment in Russia at that time that the phenomenal returns were required before an investment was made. They would only invest if they could double the money in two years.

In many developing countries, China is an example, property rights are insecure. This means short payback periods are essential for investment. Entrepreneurs must make their money quickly. This means that as investment horizons inevitably lengthened, growth will slow because more and more technologies will not be profitable to introduce into China.

The reason that export based industrialisation is a common path to economic development for poor countries is it does not threaten the existing configuration of special interests. It does not involve deregulating any domestic industry. The export industries do not threaten the business interests and profits of existing rent seekers and ruling elites.

Post-war trade liberalisation and tariff cuts gave Korean and the other East Asian Tigers much greater access to major export markets. This allowed export production to expand without limit. This expansion did not threaten local special interests because they kept their privileges and barriers to entry into the domestic markets.

Institutional reforms and imported new technologies increased employment and incomes through this explosion in exporting in Japan and the newly industrialised countries in East Asia. This allowed the losers from the economic changes to be compensated directly or with new opportunities in the export sectors (Parente and Prescott 1999, 2005; Olson 1982, 1984; Acemoglu and Robinson 2005).

Incumbent suppliers and workers are less likely to be hurt by the adoption of more efficient technologies because output expands greatly through exporting. If a market is small and limited to one country, and output cannot be increased without price cuts, greater production efficiency from a new technology can lead to less employment and business closures. Industry insiders may oppose this. Exporting reduce the incentives for insiders to block more efficient technologies (Parente and Prescott 2005; Holmes and Schmitz 1995; Olson 1982). Distributional coalitions slow down a society’s capacity to adopt new technologies and to reallocate resources in response to changing conditions and thereby reduce the rate of economic growth. 

Many other under-developed nations did not grow because institutional sclerosis locked them into yesterday’s technologies and industries with low growth and major declines in relative incomes (Olson 1982, 1984; Heckelman 2007; Bischoff 2007). A growing accumulation of distributional coalitions – institutional sclerosis – slowed down the capacity of these under-developed countries to adopt new technologies and reallocate resources across firms and industries in response to changing conditions and new opportunities (Olson 1982, 1984; Acemoglu and Robinson 2005).

Latin America is a good example of stagnation after initial prosperity because of the accumulation of barriers to efficient production. Latin America has many more international and domestic barriers to competition than do Western and the successful East Asian countries (Cole et al. 2005).

One of the tricks in the tail that the Chinese employed was market preserving federalism. Their local governments were not allowed to block outsiders as was the case in Russia as Olivier Blanchard & Andrei Shleifer explain:

In China, local governments have actively contributed to the growth of new firms. In Russia, local governments have typically stood in the way, be it through taxation, regulation, or corruption.

There appears to be two main reasons behind the behavior of local governments in Russia. First, capture by old firms, leading local governments to protect them from competition by new entrants. Second, competition for rents by local officials, eliminating incentives for new firms to enter. The question then is why this has not happened in China. We argue that the answer lies in the degree of political centralization present in China, but not in Russia.

Transition in China has taken place under the tight control of the communist party. As a result, the central government has been in a strong position both to reward and to punish local administrations, reducing both the risk of local capture and the scope of competition for rents.

By contrast, transition in Russia has come with the emergence of a partly dysfunctional democracy. The central government has been neither strong enough to impose its views, nor strong enough to set clear rules about the sharing of the proceeds of growth. As a result, local governments have had few incentives either to resist capture or to rein in competition for rents. Based on the experience of China, a number of researchers have argued that federalism could play a central role in development. We agree, but with an important caveat. We believe the experience of Russia indicates that another ingredient is crucial, namely political centralization.

The Chinese have also used what succeeded in Latin America for some time. You have politically connected partner; a family member of a politician.

China faces two major barriers to its growth. Firstly, insecure property rights will become more important because investment horizons get longer as a country develops. Secondly, political coalitions will emerge seeking the redistribution of wealth and blocking new competition.

Global median incomes to double by 2035 – @IMFnews too busy grumbling about inequality to notice