How Deng’s Drama Unfolded (Part 2)
This is the second part of our series based on a speech given by Peking University economics professor Zhou Qiren at a Chicago University seminar in 2008 to commemorate the 30th anniversary of China’s reform and opening-up. In this part, Zhou describes how China started to let the “invisible hand” of the market set prices, the corruption that came along with economic reforms, and Deng Xiaoping’s unfinished mission to reform the country’s political system. The series is being published to mark the 115th anniversary of Deng’s birth on Aug. 22 and you can find the first part here.
Seeing the invisible hand again
In May 1988, Deng Xiaoping announced that the government would “run the gauntlet on price reform.” That meant that the prices that used to be determined and regulated by the government would be open for determination by the market. Before that moment, China had already developed a “dual-track price system.” This meant that the prices of the products that were within the government’s production plan were determined by the government, but prices of the products that fell outside this plan were determined by the market. While this transitional set-up could stimulate growth, it also created chaos. The “market price” of the same product could be over ten times higher than the “controlled price.” Some people with connections took advantage of this chaotic situation to acquire commodities at a “controlled price” and re-sold them on the market. All of a sudden, “rent seeking” became very popular, and many people were angry at this situation. Deng and his colleagues decided that the only way to solve this problem was to reform the pricing system.
Price reform was described as “running the gauntlet” because previously in Poland, when the government deregulated the price of food, workers whose lives were greatly affected by this change organized several major strikes that brought down the Polish Communist Party. There was no guarantee that China’s “price reform” would not be costly or be able to proceed smoothly. Deng Xiaoping was determined to use his authority to “run the gauntlet” on price controls. He even said that it was good to attempt it while the “old folks” were still alive.
In July 1988, China announced that it would deregulate the prices of brand-name cigarettes and liquor. This was an exploratory excursion into a battle zone. In the middle of August, the political bureau meeting of the central government passed “Reform Plans on Prices and Wages.” Unexpectedly, on the same day of the publication of the meeting’s official report, people from all over the country rushed to buy large quantities of food and daily sundries and took out their savings from the banks. Ten days later, the State Council announced that it would re-consolidate price control, withhold new programs of price adjustment, raise the interest rates on savings and restore stability in the market. In September of the same year, the Politburo of the Chinese Communist Party decided to “direct and readjust” markets on a nation-wide scale. The first attempt at “running the gauntlet” was stalled.
According to my understanding after this incident, “price deregulation” under the background of persistent excessive money supply growth had turned the “invisible inflation” into “visible inflation.” And this could not be accepted by the public. This shows that even with strong political support, it is impossible to smoothly reform prices. When China entered the three year period of “directing and readjustment” of markets (1989-1991), the government used its administrative power to reduce the supply of money, suppress investment and control prices. The speed of economic growth slowed sharply and economic reform came to a stand-still.
What surprised the world in 1992 was that Deng Xiaoping gave another push for economic reform in China. He made his famous southern tour as an 88-year-old “retired party member” without specific official positions. He stated, “There is no other way out except reform and opening-up.” Deng Xiaoping raised the question that created much anxiety towards China’s reform: Is adhering to the central planning system equivalent to sticking to socialism? Is walking down the path of market economy equivalent to following capitalism? His reply to this question was unexpected: Planning and the market are but ways of allocating resources. Socialism can still follow the path of the market economy.
Encouraged by Deng Xiaoping, China decided to “run the gauntlet” on price deregulation again in 1992. In the same year, the prices of as many as 648 items of production materials and transportation and 50 prices of agricultural products were deregulated. It covered 844 counties and cities all over the country. The price of staple food, which fell under the state-unified purchase system for several decades, was now deregulated. The price of all light industrial products except salt and medicine were all opened up. By the spring of 1993, 95% of the total value of retail products, 90% of the total of price of agricultural products and byproducts, and 85% of the retail value of production materials were all determined by the demand-supply relationship on the market. The “gauntlet on price deregulation” had finally been run, and “using the market price mechanism to allocate resources” had finally become the basis of Chinese economic system.
Economists have long emphasized the market price mechanism. This is nothing new since this is the tradition of Adam Smith and conventional economics. Then why is it Deng Xiaoping was also particularly interested in the “invisible hand”? As the leader of the armed forces and as a statesman who occupied such important positions general secretary of the Central Committee of the Communist Party and vice premier of the State Council, Deng Xiaoping had hands that were more than visible! He must have known that expanding the range of market control over prices meant restricting what his “visible hands” could control. With great power in hand, he chose to “run the gauntlet” on price decontrol. Why?
I think there are three perspectives from which this question can be addressed: First, a Soviet-style planned economy turns the entire national economy into a super corporation of the nation-state. This super corporation has to put up with huge costs of operation, including the cost of collecting information about demands and production, the cost of decision-making and management, and the cost of discovering and rectifying mistakes. As a member of the first-generation leadership team in the pre-economic reform era, Deng was in charge of the nation’s frontline economic operation and was practically the manager of this super state-corporation. He knew from first-hand experience the burden of the huge costs of the old system. He also understood that over-centralization of power would result in the inability to use state power. Therefore, he wanted to reform when history gave him an opportunity to be the decision-maker of the nation-state.
Second, the reform Deng started enlightened both himself and the whole country. As a university student in Beijing from 1978 to 1982, I knew first-hand that all the new ideas and initiatives with regard to China’s economic development came from observing, comparing with, and contemplating about the experiences of the outside world after living in a relatively closed society for many years. Whether it was Europe, U.S. or Japan, the four tigers in Asia, or the former Yugoslavia, Hungary, and Poland, none of the economic units envied by China achieved their economic successes by following the model of the Soviet economy. These economic units had strategies and overall planning, but they all allowed the “invisible hand” to play a fundamental role. The price mechanism isn’t a monster. Why can’t China give it a try?
There is a third reason is somewhat more subtle. The philosophy of Deng believes that every ordinary person is equipped with a long-lasting incentive to improve his or her life. For a country to become more prosperous and achieve modernization, it has to stimulate the enthusiasm of every member of the society and basic-level organizations. It is this idea that gave rise to the delimitation of rights in Deng’s style and the re-emergence of entrepreneurship in China, which I have mentioned previously. The question is once economic reform has released the enthusiasm of individuals, families and basic-level organizations, how should we coordinate the desire to become rich inside 1 billion plus people. Deng Xiaoping emphasizes the coordination of the price mechanism because he knew that state planning cannot handle the new problem of the coordination of Chinese economy.
It is a pity that Professor Coase never visited China before or had a chance to meet Deng in person. But my guess is that they would have mutual appreciation for each other. The starting point of Coase’s theory of the corporation formulated in 1937 considers the market as the basic economic structure and emphasizes the coordination of price mechanism. This is the starting point for most economists. However, Coase already argued at a young age that the price mechanism is not cost-free. It could be rather expensive to conduct transactions on the market. In order to save on transaction costs, a term that Coase first gave definition to, the idea of a firm that does not use the price mechanism but relies on the authority of the entrepreneur and planning for regulation was born.
The starting point of Deng Xiaoping is at the opposite end, that is, the super-national firm that is established based on the elimination of all market transactions. Here since the nation uses the “visible hands” of its authority to coordinate the entire economy, it is not confined by narrowly defined “transaction costs.” However, another kind of cost, which has also been identified by Coase is “organization cost,” troubles this super-national corporation faced on a daily basis. The starting point of the economic reform led by Deng is to lower the huge organization costs of the super-national company. Thus he promoted a strategy of the division of power, the rejuvenation of the enthusiasm of individuals, families and basic-level organizations, and the re-emergence of coordination by entrepreneurs and price mechanism back onto the stage of China’s economy.
We were lucky to witness the unfolding of a historical drama: a down-to-earth economist abandoned the theoretical origin of controlling everything with the “visible hands” and moved in the direction of the real world in which coordination by entrepreneurs and price mechanism was both activated. Another down-to-earth statesman moved away from the doctrines of the planned economy towards the direction of activating both the market and the plan. The meeting point of these two people is the Chinese economy. Of course, the borders of the “visible” and “invisible” hands have not been clearly defined. Conflicts and friction are bound to occur. However, the era when the two hands held ideological hostility and viewed each other in black-and-white manner is over. A new understanding is that regulation by a plan and the price mechanism can co-exist in an economic unit, and one needs to rely on the cost of operation to draw the distinction between the two.
The challenges of corruption
Most of Deng Xiaoping’s prophecies have been fulfilled — with at least one notable exceptoin. In a field trip I made with Du Runsheng to Wenzhou in 1986, I heard about Deng’s instructions that millionaires should not be allowed, and China should not follow the path of social disparity. When we arrived in town, the locals were also having heated discussions on the same issue. Their question about Deng’s comments was: in Wenzhou, some private entrepreneurs already owned properties worth more than 1 million yuan; they were, obviously, millionaires. Was that a problem? The locals reached a conclusion that the majority of the private assets of entrepreneurs were indeed reinvested in production; only a small portion was to be used for personal and familiar consumption. So if the materials of consumption were appropriately separated from the materials of production, Wenzhou and China “had not had millionaires yet.” Therefore, there was no violation of Deng’s instructions.
Only a decade later, numerous personal consumptive properties valued more than $1 million emerged in China. Millions of premium cars have been sold in China — and they are not materials for production. Franchised stores of world-class luxury goods mushroomed in Beijing, Shanghai and Shenzhen around the year 2000; China is now the fastest growing market for luxury goods in the world. Pushed by the real estate and stock markets, many professionals, including some salary earners, have joined the club of millionaires. All these are symbols of economic achievement. However, government statistics, scholarly reports and our daily-life observations also show that China has still a sizable poor population whose average daily income is less than $1.
Scholars use the Gini coefficient to describe income disparity. They found the income gap in China increased after economic reforms. This sort of calculation may neglect the fact that “whether an income comes from legitimate sources” cannot be quantitatively described. It is one thing to say “Yao Ming has very high income” is one thing; it is another thing that “corrupt officials are making windfalls” — public opinion is against the latter, because the source of the income is unjust. Even based on the cases exposed by the anti-corruption agencies, people can see that the abuse of power and corruption continue to grow in China.
Aside from the perpetrators’ lack of sound ethical standards, what other factors can cause corruption? Steven Cheung once had a theory. In “China’s Future,” Cheung pointed out that human society has created two basic economic institutions to deal with competition for scarce resources. One uses hierarchical power to regulate people’s behavior and prevent the abuse of resources. The other uses the property rights system, that is, using the delineation of rights to define the boundaries of people’s economic activities and stimulate production, exchange, division of labor and cooperation. Furthermore, Steven Cheung predicted that when the first economic institution is moving toward the second one, which is a market economy, corruption will happen significantly because the old hierarchical privileges are going to fight for the highest “rent of power.” This process will create a specific order, that is, “institutionalized corruption,” as it was called by Steven Cheung. Later experiences in China demonstrated clearly that corruption is not only the companion of reforms; it also corrodes reforms by dissolving public support, and finally, it can bring reforms to an end. How to deal with institutionalized corruption has become a serious challenge for a transitional economy.
Deng Xiaoping proposed multiple solutions: moral education, law and order. There were plenty of ways to fight against corruption. The problem is, in the above mentioned reform processes of decentralization, redefinition of property rights, the unleashing of private businesses and the use of the price mechanism, corruption shadowed all of them and continued to sprawl — corruption seemed to run faster than reforms! Deng reached an important conclusion in September 1986: without reforming China’s political institutions, the fruits of economic reforms cannot be protected, and the reforms of economic institution cannot continue to move forward. Therefore, he started to plan China’s political reforms.
Political reforms are more complicated and difficult than economic reforms. The key problem lies in the fact that the economic interests of the status quo can be compensated by economic means; but if political reform is harming the political interests of the status quo, with what can that be compensated? For example, urban households which enjoyed the benefits of low prices were affected economically by the loosening of price controls. To deal with this problem, the government can use subsidies to compensate for the loss of urban dwellers. However, the government agencies which were in charge of price control would face cuts of budget, personnel, power and resources. For those officials who had devoted their whole lives to controlling prices, their specialized human capital expired overnight. Would they accept this situation? One may think of using economic means to compensate for the loss of power. But if the price is too low, the deal would not be accepted. If the price is too high, the state cannot afford it — a hierarchical system is indeed very expensive! Can you take away people’s power without any compensation? If so, reform means revolution.
Deng Xiaoping noted that “reform is also a kind of revolution.” But he faced another constraint. As the result of the “over-concentration of power,” China has a very strong party and political system, but very weak social organizations. This intensified the difficulty of absorbing the byproduct of political reform, that is, to re-assign those officials in other positions. Another consequence is that once the power system is shaky, it tends to cause social unrest. Therefore, in the process of promoting the reform which “is also a kind of revolution,” political stability is also the bottom-line condition. Thus we see that the political reform proposed in 1986 was not implemented in actuality. One year later, the Outline of the Reform of Political Institutions was passed at the 13th National Congress of the Communist Party. But before the outline was implemented, the failure of the loosening up of the price control and the Tiananmen Square incident took away the opportunity of China’s political reform. In Deng’s later southern tour in 1992, he promoted mainly economic reform and economic development. China’s political reform remains an unfinished task of Deng Xiaoping.
China’s economic growth has strongly endorsed the reform and opening-up policies initiated by Deng Xiaoping. His reform no doubt would be remembered in the history of China and the world, for it has evidently improved the daily lives of the largest population on earth. Surely there are multiple factors contributing to this achievement, and scholars always have different opinions. My argument, based on my observation and research, is that reform and opening-up have largely reduced the institutional costs of China’s economy, and allowed this largest developing county in the world, with its long civilization and history, to become the largest “growth economy” in the world.
Many consider cheap labor to be the foundation for China’s competitiveness. My question to this is that China’s labor and other productive factors were even much cheaper before the reforms, and why did the “made-in-China” phenomenon not happen in the global market back then? A deeper analysis than the cheap labor hypothesis would argue that the expansion of knowledge is the true basis for China’s economic achievement. Surely I would have to agree on this. But why is there a radical change of attitude toward knowledge among Chinese people, especially the younger generation? My answer is that the reform has stimulated the incentives for Chinese people to go after knowledge, and the opening-up has lowered the cost of learning. Some advantages that already exist, including the cost of key ingredients for economic growth, reduced institutional costs, and a steep learning curve have added together to build up China’s economic competitiveness. Among the three, institutional cost reduction is the true secret of China’s experiences.
Deng Xiaoping initiated China’s reform and opening-up and paved the road of China’s economic growth. But he didn’t complete China’s reform and opening-up. China has a lot of unfinished tasks: the delimitation of rights, the unleashing of entrepreneurism, the institutional framework of the market economy, and the regulation of the power of the state. As one of the results of the gradual reform strategy, many difficult reforms have been postponed. The social conditions which contextualize the hard reform tasks are constantly changing. In the time when we are having this conference, global financial fluctuations and rising oil price are bringing new tests to the world. Constrained by the lagging reforms of exchange rates, interest rates, resource prices and administrative monopoly, it remains uncertain if China can deal with the new challenges and keep its economic growth going.
I was fortunate to hear Steven Cheung’s comments at his 70-year birthday in Shenzhen at the end of 2006: “The Chinese have created the best economic institution in human history.” My own observation does not allow me to be as optimistic as he was. But China’s experiences in the past 30 years have proved that the future is open-ended. I would hope that China’s development will prove once more that Cheung’s statement is correct.
Zhou Qiren is a professor with Peking University’s National School of Development. He specializes in studies of China’s reform and development.
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