Some analysts have argued that the omission of the phrase “the market plays the decisive role in resource allocation” in the Communique of the Third Plenum – although it was mentioned in the longer Resolution – signified a downgrading of the role of the market in the Chinese economy and more importance assigned to government regulation. Last week, Justin Lin, Professor of Economics at Peking University and former Chief Economist at the World Bank, gave his view on the matter in an extensive interview for the series “Open Questions” of the South China Morning Post. Prof. Lin's theory of “new structural economics” – which advises governments of developing countries to take an active role in building and optimizing their industrial base – is widely believed to have influenced China’s economic policies over the past decade. He has also predicted that China will “surpass the U.S. in GDP as measured by market exchange rate, around 2030” and surmount the middle-income trap “within two or three years”. In the interview, Prof. Lin focussed on the relationship between governments and markets.
One thing receiving attention in China is the future of market-oriented reform. The omission of mentioning the market’s “decisive role” in resource allocation in the Plenum's Communique triggered some concerns about a downgrade of the role of the market. Prof. Lin: “Having already been designated as playing a “decisive role” in resource allocation, it is difficult to find words that can emphasize the role of the market even more. It is known that market failure is a common phenomenon in economic development. Therefore, the Third Plenum proposes to optimize the role of the government and ensure effective regulation to “remedy market failure”. Where does market failure occur? It may be different across industries and stages of development. Thus, if the government wants to play a better role, it must be flexible and take measures according to the situation. So this is not a downgrade of the role of the market, but a further explanation and improvement of the role of government, of which the ultimate purpose is to let the market play a decisive role in resource allocation. The Third Plenum's decision also said the government should “lift restrictions”, but when there is market failure, or when a monopoly occurs, it must “strive to better maintain order”. From the perspective of new structural economics, an effective government is the condition for an efficient market, and an efficient market is the goal of an effective government.”
“Why is an effective government the condition for an efficient market? Because if the government does not manage or intervene when there are market failures and monopolies, the market won’t be efficient. And what is the purpose of the government’s actions? It is to make the market more efficient, so an efficient market is the goal for effective governance. Market failures will not disappear if the government does nothing. But if what the government does exceeds what an efficient market needs, it may hinder the market from playing a decisive role in resource allocation. So this is a balancing act. To sum up, a decision on improving the market has been made in response to the new situation of China’s current stage of economic development. Government policies must be flexible: restrictions should be further lifted accordingly to help enterprises seize development opportunities. But when monopolies and systematic risks occur, the government should be able to maintain order.”
On China industrial policy, Prof. Lin explained that “economic development requires continuous technological innovation and industrial upgrading, which in turn require research and development (R&D). In the process of innovation, there will inevitably be many market failures. As the product of research is a public good that does not yield high profits, enterprises may not be willing to invest if the government does not support them. And if the government does not provide patent protection to new inventions, firms will not be willing to develop new technologies either, as it can be easy for others to copy.
For developing countries, we must continue to climb up the industrial ladder, from industries with low productivity to those with high productivity. Of course, if you want to succeed in the process, there is a very basic principle: it must be based on comparative advantage. If you violate the comparative advantage principle, you may fail as a pioneer and bear all the costs. But the failure can warn latecomers against jumping in. When the pioneers succeed, everyone will know that this new industry is in line with our comparative advantage and will then follow, which leads to competition. In this stage, the pioneers can only earn average profits at the same level of the latecomers. So regardless of success or failure, the industrial pioneers will create useful information for society. However, cost and benefit are asymmetric. If the government does not provide compensation for the information externality created by first movers, no one will be willing to become one, and the industry will no longer be upgraded. The new industry may also need a lot of things that entrepreneurs cannot or are reluctant to provide, such as workers capable of using the new technology, because the firms may find the workers they have invested huge amounts of money in to train can be easily attracted away by latecomers and competitors with slightly higher wages. Other examples include infrastructure, financial and legal institutions. But the resources that the government can leverage are limited, so it should allocate limited resources to those industries with comparative advantages. Such action is industrial policy,” Prof. Lin said in the interview.
The full interview is available here but may require an online subscription.
