The Undercover Economist Part 10

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"I see. Yes."

"That was the tallest one standing ten years ago."

"My G.o.d," I said.

The ambition of it all was simply exhilarating. In just a decade, the builders of Shanghai had put up a fair imitation of Manhat-tan. What New Yorkers would have made of it, I don't know. It made us Londoners feel like country b.u.mpkins.

Yet it could all have been so different. For most of the twenti-eth century, China was poorer than Cameroon. In 1949, when the People's Republic of China came into being, the world's larg-est country was torn by civil war and ruled by a communist dicta-torship. In the late 1950s, millions of people died in a famine induced by the failed policies of the government. In the 1960s, the university system was destroyed by the Cultural Revolution, when millions of educated citizens were forcibly relocated to work in the countryside. After all this, how did China become the great-est economic success story in history?

Two farming revolutions A visit to Shanghai is enough to provoke the question. Clues to the answer can be found all over China. I picked up several of them on a train to the inland Chinese city of Zhengzhou.

The train itself was the first clue: it was more comfortable, faster, and more punctual than those back in England. China's road and rail network appeared to be in superb condition. Sec-ond, the Chinese seemed to have an excellent education system- I was soundly but politely thrashed at chess by a PhD in economics, a young man who had never been outside China but who spoke mildly and thoughtfully in good English. Third, al-though the train was packed, there were few children and no large families. China's "one child family" policy has created a society where women have time to work and where the bulk of people are neither old nor young but in middle age, saving for the future. Those vast savings have provided the investment money for the roads, the trains, and more. At the minimum China clearly had the human resources, infrastructure, and financial capital required by traditional models of economic growth. Yet it did not always seem as though these resources would be well used; we already know that without the right incentives they will be wasted.

Under Mao, that waste was legendary. China's initial develop-ment efforts were two-p.r.o.nged: ma.s.sive investment in heavy in-dustry such as steel, plus application of special agricultural techniques to make sure that China's vast population was fed. The policy focus was understandable. China's northern prov-inces are rich in high-quality coal, which logically could pro-vide the basis of an economic revolution. Coal, steel, and heavy manufacturing had been the basis of the industrial revolution in the leading economies: the United Kingdom, the United States, and Germany. Meanwhile, agriculture had to be a priority for any Chinese government because there was barely enough fer-tile land to feed the country's hundreds of millions of people. From the window of the train to Zhengzhou I was looking out over Henan, China's most densely populated province. It is a freezing desert.

This two-p.r.o.nged push was called the "Great Leap Forward." It seemed to make sense, but it was the greatest economic failure the world has ever seen. Mao conducted economic policy based on the hidden premise that if people tried hard, the impossible would happen. Zeal alone was sufficient. Villagers were ordered to build steel furnaces in their backyards but had no iron ore to put into them. Some villagers melted down good iron and steel- tools, even doork.n.o.bs-in order to meet the quotas demanded by the state. Even Mao's personal doctor worried about the wisdom of a policy to "destroy knives to produce knives." The steel that emerged from the furnaces was unusable.

If industrial policy was a farce, agricultural policy was a trag-edy. The Great Leap Forward had already pulled many workers off the land to labor at the furnaces or in public works like dams and roads. Mao ordered the people to kill grain-eating birds, and the population of insect pests exploded as a result. Mao person-ally redesigned China's agricultural techniques, specifying closer planting and deeper sowing to increase yields. Rice planted so closely together could not grow, but party officials, anxious to please Mao, staged shows of agricultural and industrial success. When Mao traveled by train to admire the fruits of his policy, local officials built furnaces in strips along the railroad and brought rice from miles away to replant, at the officially specified density, in adjacent fields. Even this charade could not be maintained without the use of electric fans, which were used to circulate air and prevent the rice from rotting.

Crop yields fell, of course, but even this would not have been disastrous without the state's insistence that the policy was work-ing. When the defense minister raised the issue of the famine in a ministerial meeting, he was punished and ordered to write a "self-criticism." Less powerful figures who denied that there was a surplus were tortured. While crops were failing, China doubled its exports of grain from 1958 to 1961 as a symbol of its success. In Henan province, across which we were traveling in comfort just forty-five years later, state grain stores contained enough food to provide for the people but remained shut because the official government position was that there was a grain surplus. Mean-while, people starved to death outside in the snow. Some were left unburied, others were eaten by desperate family members; neither fate was uncommon.

Estimates of the death toll from the famine range from 10 million to 60 million people, roughly the entire population of England, or of California and Texas combined. Even Chinese government figures later acknowledged that 30 million people had died, although they blamed bad weather.

In the "world of truth" described in chapter 3, such disasters cannot happen. Mistakes, certainly, will be made-perhaps more frequently than under central planning. But the mistakes stay small; in market economies we call them "experiments." If ven-ture capitalists back them, they do not expect many to succeed. When they succeed, they make some people rich and bring in-novation to the whole economy. When they fail-which is more often than not-some people will go bankrupt, but n.o.body will die. Only command economies can promote experimentation on such a fatally extravagant scale and suppress informed criticism. (Mao was not alone. The Soviet president, Nikita Khrushchev, made a similar mistake following a visit to the United States, when he ordered Soviet fields to be replanted with the corn he had seen growing in Iowa. The failure was a catastrophe.) It is worth re-membering that market failures, while sometimes serious, are never as tragic as the worst failures of governments like Mao's.

In 1976, after many more crimes against his own people, Mao died. After a short interregnum, he and his followers were re-placed by Deng Xiaoping and his allies in December 1978. Just five years later, the change in China's economy was incredible. Agricultural output, always the headache of the Chinese plan-ners, had grown by 40 percent. Why? Because those planners had brought the "world of truth" into China. As we discovered in Cameroon, incentives matter. Before 1978, China had some of the most perverse incentives in the world.

Before Deng took power, Chinese agriculture had been lo-cally organized into collectives of twenty or thirty families. People were rewarded with "work points," which were awarded based on the output of the collective as a whole. There was little op-portunity for personal improvement either through extra effort or ingenuity. As a result there was little of either.

The government also purchased and redistributed food from regions that produced a surplus, but did so at a severely depressed price, discouraging more fertile regions from making the most of their agricultural land. Many rural workers were underemployed. The very system that was designed to boost China's agricultural output and make the nation self-sufficient was undermining it. China's output of grain, per person, was as low in 1978 as it had been in the mid-1950s, just before the Great Leap Forward.

Deng had little time for such folly and immediately embarked on a program of reform, announcing that "socialism does not mean poverty." To improve agriculture, he had to get the incen-tives right. He started by raising the price paid by the state for crops by nearly a quarter. The price paid for surplus crops rose by more than 40 percent, substantially increasing the incentive for fertile areas to produce more crops.

At the same time, a few collectives experimented with subcontracting land to individual households. Instead of clamping down, the government allowed the innovation to see whether it would work, just as a market economy allows small-scale experiments. Households who were renting land from collectives had every incentive to work hard and think of smarter ways of doing things because they were rewarded directly for their successes. Crop yields immediately increased. The experiment spread: just 1 percent of collectives had used the "household responsibility system" in 1979; by 1983 98 percent had switched to the system.

These reforms were linked with a number of other pieces of liberalization: the retail price of grain was allowed to rise, further increasing the incentive to produce what was needed. Restric-tions on trade between regions were eased, so that each region could enjoy its comparative advantage. Production quotas were soon abandoned altogether.

The results were dramatic: agricultural output expanded by 10 percent a year in the first half of the 1980s. More impressively still, more than half of the increase was attributable, not to work-ing harder or using more machinery but to more efficient farm-ing and harvesting methods. Much of that productivity increase was directly attributable to the abandonment of the collective system. In the five years following the reforms, the average real income of farmers doubled. It was not Mao but Deng, by using the power of markets and prices, who had achieved the great leap forward.

All these statistics are best understood by thinking back to chap-ter 3 and the world of truth. Partly by accident, partly by benign neglect, and partly by design, Deng introduced the world of truth to Chinese agriculture. Those who had good ideas, good luck, and who worked hard, prospered. Bad ideas were quickly aban-doned. Good ones spread rapidly. Farmers grew more cash crops and devoted less effort to crops that were difficult to grow; all of this was the unsurprising result of introducing a price system. China had begun to travel along the so-called capitalist road.

Such a journey cannot be completed on rice alone. The success of the agricultural reforms created the momentum and popular support for Deng to continue. Attention needed to be turned to the rest of the economy-and to cities like Zhengzhou.

Investing for the future Zhengzhou is not a stunning city like Shanghai. It is ugly and crowded and, despite being a major railroad intersection, some-what insular: we spent nearly a week in the Zhengzhou area without seeing a single foreign face. In its own way, though, Zhengzhou is as impressive as Shanghai. A city the size of Lon-don far from the Western world, affectionately described by our guidebook as "a sprawling paradigm of ill-conceived town plan-ning," Zhengzhou at least demonstrates that China's economic revolution has spread beyond the coastal provinces. Forty-story high-rises loom solidly over the enormous train station; there are plenty of modern banks, huge department stores and hotels, and brutal concrete overpa.s.ses. Advertising is everywhere.

To construct such buildings, rails, and roads requires an enormous investment. Economists have a label for the roads and factories, homes and office buildings, which result from investment: they call such constructions "capital," and all sustained development needs capital. Capital can come from private investors, both domestic and foreign, who hope to recoup profits, or it can come from the government, either by taxing people and investing the proceeds, or by a program of compulsory saving.

Common sense suggests that if you want to be richer tomor-row than you are today, you should invest money rather than spending it on goods and services to be enjoyed immediately. You could invest it in an education, in a house, or in a bank ac-count. Either way, if you consume less today and invest the money, you will be richer tomorrow-if the investments are good ones. (Building blast furnaces in the back garden will not do. Neither will building a library with a leaky roof.) An unmysterious chunk of the development of countries is based on the same simple principle that saving and investing to-day makes you richer tomorrow. Savings rates have been very high in the fast-growing economies of the Pacific Rim. How-ever, that is not the whole story, as we learned in chapter 8. A market economy cannot simply decide to save and invest more. Most people don't bother saving in Cameroon: they have few ways to recoup investments in basic infrastructure like roads, and little confidence that they will be allowed to do so if they build factories or shops. The few exceptions, such as the cell-phone sector, which can be funded by pay-as-you-go cards, have been the stunning successes you might expect. Many poor economies seek foreign investment but cannot even retain the confidence of their own citizens, who are eager to invest money overseas. Small wonder that savings rates are low, and the percentage of those savings invested inside Cameroon lower still. Without offering a secure environment for investment, the Cameroonian govern-ment can do little to encourage it.

China's socialist government had no problem with access to capi-tal. While a market economy cannot simply decide to save and invest more, a socialist economy can and usually does. Capital came from government programs; almost all saving was done ei-ther by the government or by state-owned corporations. In both cases money was being taken out of the pockets of individuals and invested on their behalf. There was plenty of capital available, too: about a third of national income was saved rather than consumed, roughly twice as much as in Cameroon.

Initially, China was able to get fairly good returns out of this capital. In the early 1950s, when the main task was to rebuild essential infrastructure and industry, every 100 yuan invested added 40 yuan to China's annual output, an impressive return. This should not be surprising. The tasks facing the Chinese gov-ernment were clear enough: in particular, what had been broken during the war and the revolution needed to be fixed. All that was needed was for the government to give the orders.

The trouble came later. Even setting aside the chaos of the Great Leap Forward and the Cultural Revolution, the Chinese state found itself increasingly unable to get value out of its in-vestments. By the time Mao died in 1976, every 100 yuan in-vested were adding only 18 yuan to China's annual output. This was less than half as efficient as two decades before. Given that the government and state enterprises were, between them, in-vesting such a large chunk of the nation's income, this reduction in the efficiency of investment was a crippling waste.

A sympathetic observer might conclude that it was inevitable that after the obvious investments had been made, returns would fall. This might be true for a cutting-edge economy like j.a.pan or the United States, but in 1976 China was still desperately poor. Few people had cars, telephones, electricity, or running water. In such a poor country, the right investments can achieve very high returns by providing such basics of modern life. There was plenty of effective investment to be made, but the state didn't know how to make it.

As long as it was obvious what to order people to make or to build or to grow, this didn't matter much. But as the population grew, technology advanced and long-demanded investments were made, the communist economies slipped farther and farther away from the memory of the price system. Real market economies change quickly. In South Korea, 80 to 90 percent of workers, land, and capital were working or being used for different pur-poses in the 1970s than they had been in 1960-in 1960, agricul-tural output was 45 percent of the economy and manufacturing output less than 10 percent. By the early 1970s, the manufactur-ing sector was larger than the agricultural sector. More impor-tantly, within those sectors, workers were training and retraining, firms were starting up and closing down. Korea's export indus-tries used to make toys and underwear, but now they make memory chips and cars. If, in 1975, a planner for the South Ko-rean government had tried to run the economy based on out-dated information from 1960, the result would have been a catastrophe. Fortunately, n.o.body did. Such folly was left to the North Koreans. Command economies from North Korea to the Soviet Union to China simply lacked the information necessary to keep making the right choices.

Unlike Cameroon, where individuals and companies have little incentive to invest, Maoist China had no problem with incentives- after all, the leaders had the power of life and death over their followers. But incentives alone are not enough. Chapter 3 showed that the world of truth created by markets produces good out-comes not just because it provides incentives, but because it gen-erates information about the costs and benefits of all kinds of goods and services through the price system. The socialist sys-tems of the Soviet Union and China provided the strongest in-centives imaginable, but not the information necessary to use them correctly. Rather than responding to demand from world markets, like the South Koreans did, the Chinese responded to demands from Mao: plant crops more closely, kill birds, melt down your tools to make new tools.

To get any value out of the vast sums of investment capital available, the Chinese government began a gradual shift to a market system. Where successful agricultural reforms had paved the way, more complex and far-reaching reforms of the whole economy were to follow. Fifteen years after Deng came to power, returns on investment had quadrupled: for every 100 yuan invested, China's annual output grew by 72 yuan: each investment paid for itself after just 500 days. Nor was this because the government had scaled back its investment and was cherry-picking only the very best projects. Quite the reverse: investment levels were even higher than in the 1970s. It's small wonder the economy grew spectacularly. But how were the high returns to investment achieved?

Growing out of the plan Like the Soviet bloc economies, China's industrial sector was controlled by planners. The plan specified, for instance, that a particular steel mill would produce a defined quant.i.ty of steel, that that steel would then be used for certain specified purposes, and that a standard quant.i.ty of coal (0.8 tons of coal were said to be required for each ton of steel) would be delivered to the steel mill in order to make production possible, and so on. The calcu-lations required were tremendously complex, even presuming that junior bureaucrats were supplying honest information about costs and quality. (Everybody had an incentive to claim that the machinery and materials they had to manage were insufficient and of poor quality, and to claim that nevertheless their output was vast and excellent. Without a world of truth, the real story was impossible to uncover.) But, leaving aside Mao's fatal uto-pian whims, such a system could work tolerably well for a time because each year the planners had the previous year's plan to guide them.

As the economy grew and changed, the process of adjusting output requirements and making capital investments wisely be-came increasingly difficult: this is why the returns to capital in China were so much lower in 1976 than in the 1950s. A market system would have done much better, but it was no simple mat-ter to create one. Markets do not work well without market-supporting inst.i.tutions: in a market economy, people need banks for commercial loans, contract law to resolve disputes, and confi-dence that their profits will not be confiscated. Such inst.i.tutions cannot be set up overnight. Meanwhile, many workers in a socialist economy are engaged in unproductive activities and might simply starve unless the adjustment process was phased in or they received some kind of compensation. The problems were most acute for the industrial sector of the economy because it was most closely tied into the plan system, was the vehicle the government used to generate savings, and was the source of most government investment.

Had Deng decided simply to abandon the plan and switch to a market system overnight, the likely outcome would have been a scramble to establish property rights, the collapse of the finan-cial sector (because many government-run banks had made loans that could never be repaid), and widespread unemployment, even starvation. It is conceivable that things might have worked out for the best quite quickly, but it is likely that they would not. (In the former Soviet Union in the 1990s, such "shock therapy" re-sulted in economic collapse.) What is more, such extreme reforms would have offended so many vested interests-including huge numbers of ordinary people-that they might have been politically impossible. Deng, who had been purged twice under Mao's chairmanship yet re-turned to lead the country, well understood the value of political credibility.

So Deng and like-minded reformers adopted a more tentative strategy. In 1985 the size of the "plan" was frozen: the production levels specified by the government did not grow as the economy grew. Instead, state-owned firms were allowed to do as they wished with any extra production. Efficient coal manufacturers would find that efficient steel manufacturers wanted to buy extra coal to make extra steel, which would be sold on to efficient construction firms. Inefficient firms that tried to expand got nowhere.

This strategy turned out to work very well for several reasons. First, it was easy to understand, and the commitment to freeze the size of the plan was a credible one. Such a credible commitment was important: if the planners had constantly tried to expand and update the plan in the light of the information emerging from the fringe market, that market would quickly have ceased producing useful information. Plant managers, realizing that any successful changes they made would quickly be absorbed into next year's plan, would have stuck to safe choices.

Second, because the plan was kept fixed, a certain stability was guaranteed. Workers who had jobs could keep them. Things were guaranteed not to get worse-but if growth resulted, there was the possibility that they could get better. Many people grabbed that possibility, preferring long hours and poor conditions in a textile factory, even if they had to travel thousands of miles from their families, to their previous occupation of sc.r.a.ping a living- or failing to do so-on the most marginal, arid farmland.

Third, the market operated exactly where it needed to: at the margin. Remember that marginal costs and marginal benefits are what really matter for the efficiency of an economy. Imagine the decision of a factory manager trying to decide whether to pro-duce one extra ton of steel, from which he can keep the profits. If he knows the marginal cost (the cost of producing one extra ton) and the price he is offered is a market price (which reflects the benefits to someone else of one extra ton), then he will make the right decision: produce if the price is higher than the marginal cost. The output of the factory will be efficient.

Decisions about what happens to the rest of the steel are not important for whether the quant.i.ty of output is efficient. Nine tons out of ten could be produced and allocated in accordance with the plan, but it is the decision about the tenth ton that matters for efficiency.

What this meant was that efficient firms expanded to meet extra demand: an eleventh ton and a twelfth followed the tenth. That demand was coming from expanding sections of the economy, which really needed supply, rather than from the plan-ners. Managers got to keep profits and reinvest them-and had an incentive to make sure that the investments were profitable.

Inefficient firms, by contrast, did not grow. As long as the government kept subsidizing them through the plan (it gradually stopped doing so in the 1990s), they could still keep producing forever; but since the Chinese economy was well over four times as big in 2003 as it had been when the plan was frozen in 1985, the relative importance of those firms shrank very quickly. The economy, quite literally, grew out of the plan.

Entry and scarcity power We know that a market system limits the scarcity power of firms; most firms face compet.i.tion, and sectors of the economy that are not very compet.i.tive tend to attract new compet.i.tion over time. The compet.i.tion and free entry of new firms, by limiting scar-city power, pushes powerfully toward efficient production, new ideas, and consumer choice.

The Chinese reformers needed to encourage entry and limit scarcity without resorting to a dangerously unpredictable strat-egy of rapid liberalization. They hoped to improve the perfor-mance of the state sector, introduce new public sector companies as compet.i.tors, gradually foster a private sector, and slowly open up to international compet.i.tion. If one source of compet.i.tion didn't work out, there was always another. The most important compet.i.tors at first were local-government-owned "township and village enterprises." Despite the name they were often huge in-dustrial monsters. Later, privately owned and foreign companies were allowed to set up and grow, too.

As late as 1992, only 14 percent of industrial output was being produced by privately owned or foreign firms, while the state sector was responsible for nearly half of output. The output of local-government township and village enterprises made up most of the remainder. The Chinese economic miracle was not really about privatization. What mattered was not who owned the com-panies, but that the companies were forced to compete in a rela-tively free market, driving down scarcity power and bringing in the information and incentives of the world of truth.

The effects are even measurable. Remember, way back in chapter 1, we discovered that high profits were often a signal of scarcity power. If new entry and stronger compet.i.tion were removing the scarcity power of state-owned firms, we would expect their profit rates to fall.

That is indeed what happened. Chinese firms in the 1980s had very high rates of profit: many sectors had profit rates of over 50 percent (for a fairly compet.i.tive economy, you would expect not more than 20 percent and often much less). Profits also varied a lot from sector to sector depending on the arbitrary pricing of the plan: the oil refining sector had a profit rate of almost 100 percent, the iron mining sector just 7 percent. In all cases, the government confiscated the profit and reinvested it.

As the economic reforms began to bite, profits started to fall; they also started to converge, as the most profitable sectors faced the fiercest compet.i.tion from local government, private, and for-eign firms. During the 1990s, average profit rates fell by over a third; in the juiciest sectors they fell by at least a half. The effect of all this was to reduce waste, give Chinese customers better return for their money, and make China a potential player on world markets. Scarcity power disappeared.

China and the world There have been times in China's history when it has been an insular place. This is not one of them. Far from the coast in the inland cities of Xi'an and Zhengzhou we had no difficulty finding c.o.ke, McDonald's, pool rooms, and Internet cafes. In Shanghai it was almost impossible to escape from familiar brand names.

Anyone who visited China in the early 1990s could tell you that this is all very new. But it's more than an anecdotal impres-sion: the statistics tell the same story. As recently as 1990, China was a minnow on the global trading scene. The United States and Germany exported almost ten times as much. Last year, China became the fourth largest exporter in the world, and even the United States and Germany export less than twice as much. This is no accident. The dramatic entry of China onto the world's economic stage has been one of the last acts of China's economic reform.

Why did China need the world? A country of over a billion people seems better placed than most to be self-sufficient. But China's economy was still tiny in 1978-smaller than Belgium's- and the reformers realized that engaging with the world could help. There were three advantages. First, China could tap into world markets for labor-intensive goods: toys, shoes, and clothes. Second, the foreign currency these exports earned could be spent on raw materials and on new technology to develop the economy.

Finally, by inviting foreign investors in, the Chinese could learn modern production and business techniques from them-hugely important for a country that had been communist for decades. Last year, China and Hong Kong managed to attract over 40 percent of all the foreign direct investment into the world's de-veloping countries. (India, the other Asian giant, attracted a little over 2 percent.) As we discussed in chapter 9, one advantage of such investment is that it supplies capital to an economy that cannot be instantly withdrawn if investors get nervous. This hap-pened to China's neighbors in the Asian currency crisis of 1997, where purely financial investments like loans were rapidly with-drawn in a ma.s.s panic. The capital investment expands the fu-ture capacity of the economy, but as we have already seen, China did not need foreigners to supply capital. It was the expertise that really counted: expertise, for example, in quality control or in logistics.

American and j.a.panese firms made investments in transporta-tion and electronics, turning China into a high-technology manu-facturer. You can see the effect of these investments in the statistics: China is now the largest producer of the majority of important consumer electronics; more than half the world's DVD players and digital cameras are now made in China. You can also see the effect while wandering around the country. Sitting on the buses around Zhengzhou, I was surrounded by people talk-ing on hi-tech gizmos that I'd never seen before, and which didn't arrive back home for months. The foreign investors who made the technology possible hope for a good return on their invest-ments, but it is obvious to anyone that plenty of the money is staying with Chinese consumers.

Foreign investment has been a major factor in keeping China's reforms on track. Not only did foreign firms bring capital, and not only did they bring expertise and connections to the world economy, they also continued the compet.i.tive process of the ear-lier reforms by competing with China's domestic firms, driving them to continue improving their efficiency.

If foreign investment is such a boon for the economy, how did China do it? Why didn't the money go to India? Why didn't the money go to Cameroon?

Luck plays a role. In contrast to Cameroon, the Chinese had a substantial and rapidly growing domestic market, always attrac-tive to foreign investors. No Cameroonian leader, no matter how gifted, could copy this: fate dealt Cameroon a different hand. There was nothing lucky, however, about the Chinese commit-ment to education-one happy legacy of the communist years- which meant that by 1978 there was a huge reservoir of skilled and potentially productive workers, waiting to flood the economy with talent when the dam of the command economy burst. Cameroon's government wasted any opportunity it had to edu-cate its people back in the 1970s, when the country was richer than it is today. But India also has a large and growing domestic market and a well-educated workforce, even though that educa-tion is less broadly available than in China; the statistics show popular hysteria about outsourcing notwithstanding, this has not yet been enough to attract foreign investors.

China had other natural advantages that India did not. The often-painful process of international economic engagement was made smoother and more effective because of mainland China's links with Hong Kong and Taiwan. Both were successful inter-nationally integrated economies back in the days when China was very isolated from world markets, and despite the different economic systems there were close ties of family and friendship between businessmen in the three economies. These social ties helped compensate for problems in China's legal system in the early years of reform. China was (and still is) striving to improve the commercial framework of property rights and contract law, which all successful economies need. Without such a framework it is hard to do business with confidence. How can you trust that your business partners will not rip you off? How can you feel safe if local government officials can confiscate your profits or your property?

For entrepreneurs from Hong Kong and Taiwan, personal connections meant that they were often able to rely on promises with no legal basis. A formal contract would have been better, but a businessman's word could be good enough if the opportunity for profit was attractive.

In this case, it certainly was. There was a perfect fit between China and Hong Kong. Chinese firms, producing cheap goods but unused to international deals, tapped into the expertise of Hong Kong traders. Chinese exports to Hong Kong grew dra-matically in the 1980s, and Hong Kong re-exported them to the world. Taiwan joined in during the 1990s. As the economist Dwight Perkins observed at the time, "the formidable marketing talents of Hong Kong and Taiwan are being grafted onto the manufacturing capacity of the mainland."

India lacked Hong Kong and Taiwan, but also lacked any interest in welcoming foreigners. The noted Indian economist, Jagdish Bhagwati, described his own governments' policies from the 1960s to the 1980s as "three decades of illiberal and autarkic policies"- in other words, the government sat hard on the market and did its best to prevent trade and investment.

China, on the other hand, worked hard to attract foreign in-vestors and to make the most of the links with Hong Kong and its other neighbors. The plan was to create "special economic zones," such as Shenzhen, where the normal rules of the com-mand economy would not apply to foreign investors. At the same time, the infrastructure of the special economic zones could be improved quickly. That method perfectly complemented China's connections with Hong Kong, Macao, and Taiwan: the zones were exclusively in Guandong Province, next to Hong Kong and Macao, and Fujian, next to Taiwan. Over half of all investment into China in 1990 came from the tiny country of Hong Kong, while j.a.pan and the United States together supplied only a quar-ter. Further, almost half of all investment arrived in Guandong; Fujian was the second largest recipient. The city of Shenzhen, across the border from Hong Kong, was a fishing village in 1980 when it became a special economic zone. Twenty years later prop-erty developers were pulling down skysc.r.a.pers mid-construction to start building bigger skysc.r.a.pers. The Chinese say, "you'll think you're rich until you set foot in Shenzhen."

Unfair and arbitrary as they were, the special economic zones worked well at attracting investors without turning the entire Chinese mainland upside down. They also provided a toehold for reforms to spread. Whenever the rules for foreign firms seemed to be working well, administrators started applying them to domestic firms within the zones. Then they started applying them to domestic firms outside the zones. Other coastal prov-inces looked at the booming economies of Fujian and Guandong and started to demand similar privileges. Unfair or quirky rules were straightened out as foreign investors protested any special favors for domestic firms, while domestic firms circ.u.mvented special favors for foreign firms by laundering their money through Hong Kong and bringing it back as "foreign investment." As so often with the rest of China's reform program, good policies were copied and foolish ones died out quickly.

Epilogue: does the economy matter?

This chapter is called "How China Grew Rich." That's an exaggeration. China is not rich-yet. But it is growing richer faster than any country in history.

And yet . . . so what? With this economic growth comes tremendous upheaval. Chinese people are confused; many are unemployed or dislocated from the modern China. A group of workers in Sichuan came to believe that Mao was running a factory in the afterlife-according to socialist principles, naturally. One account claims that some of them killed themselves with the aim of joining him.

Contemporary Chinese films also tell a story of bemus.e.m.e.nt and at times agonized searching. Many films, such as Shower and Happy Times Hotel, feature families split up after someone seeks his fortune in Shenzen. The movies show the heartache but not the riches. The message is that the new opportunities are de-stroying the old way of life. Another common theme is of total confusion: the hapless bike messenger of Beijing Bicycle discovers that property is indeed theft, and his attempt to engage with the capitalist system ends in misery and violence. In the touching farce Happy Times Hotel, well-meaning friends, unemployed after their factory unit has closed down, are so busy trying to look after a blind girl by faking the existence of a business that they fail to appreciate it would be easier simply to run a real business. It is only the girl, who grew up in the 1990s, who comes to see clearly that she has the ability to make a living for herself.

It is not easy to be part of a revolution. Young men and women growing up in rural China in the 1970s worked as part of a farming community, collecting "work points," doing as they were told, moving where they were told, and having basic needs provided for by the community and the state. Their sons and daughters grew up in a different China in the 1980s and 1990s. Life was still hard, but there was more money around and much more choice. Land was valuable; as farming methods improved, there was still less need for spare workers on the farm. Some people did what their fathers had been forbidden to do: sold their land and moved to the cities to look for work. Migration tore families apart. While new opportunities opened up, the old safety nets were becoming tattered as some state enterprises became obsolete.

Meanwhile, conditions in factories are terrible. Badly paid employees work long shifts under conditions of dubious safety. A BBC reporter picked up the stories of Li Chun Mei, who died in late 2001 at the end of a sixteen-hour shift; she was found by her co-workers lying on the bathroom floor, blood oozing from her nose and mouth. Then there is Zhou Shien Pin, whose feet melted after he touched a high-voltage wire in a paint factory. Is this the price of economic growth? Is it worth paying?

Economists like Paul Krugman, Martin Wolf, and Jagdish Bhagwati have repeatedly tried to argue that Chinese sweatshops beat the alternatives. This is not a popular view. After Martin Wolf's book, Why Globalization Works, was reviewed in the Guard-ian Weekly, the paper published an outraged letter from a reader who fantasized with glee about Wolf himself being forced to work in a sweatshop.

This response is about as vicious as wishing that anyone who wears a "Mao" T-shirt be condemned to starvation-but less logi-cal. Martin Wolf is correct to suggest that the sweatshops are better than the horrors that came before them, and a step on the road to something better. Mao's "Great Leap Forward" was a leap into h.e.l.l.

Nor is it unfair or irrelevant to compare modern China with Mao's utopia. Countries that are rich or rapidly growing have embraced the basic lessons of economics we have learned in this book: fight scarcity power and corruption; correct externalities; try to maximize information; get the incentives right; engage with other countries; and most of all, embrace markets, which do most of these jobs at the same time. Cameroon's poverty costs lives- because poverty kills-and it also robs people of their autonomy and ability to make meaningful choices about their own lives. India, which has done better than Cameroon but fallen far be-hind China, remains so poor that half a million citizens are dis-figured by leprosy, a disease that can be cured for the price of a beer. Meanwhile communist China and the Soviet Union killed tens of millions, often through pure economic failure. Econom-ics matters. The contrast between Cameroon, India, or Mao's China and America, Britain, or Belgium could not be greater.

In the end, economics is about people-something that economists have done a very bad job at explaining. And economic growth is about a better life for individuals-more choice, less fear, less toil and hardship. Like other economists, I believe that sweatshops are better than the alternatives and without a doubt better than starvation under the Great Leap Forward or in "mod-ern" North Korea. But if I did not also believe that they were a step to something better, I would not be such an enthusiastic supporter of China's reforms.

That is why I was very cheered by the latest news from China. The wealth has not been evenly spread, but it is slowly seeping inland from the "Gold Coast" of Shanghai and Shenzhen. The inland economy of China grew very strongly-by 7.7 percent an-nually between 1978 and 1991. Between 1978 and 1995, two-thirds of China's provinces grew faster than any country elsewhere in the world. But most importantly, the people of China are feeling the difference. After years of paying low wages-because the supply of migrant labor from China seemed unlimited-factories on the Gold Coast are starting to run out of willing workers. Foreign-owned factories pay a bit more and enjoy easier recruitment and lower turnover. But wages will have to rise and conditions will have to improve, because inland China is catching up.

In 2003, Yang Li did what many Chinese workers have done: she left home to work in a sweatshop in the Pearl River delta. A month later, after working thirteen-hour shifts, she decided to go home and start her own business-a hair salon. "Every day at the factory was just work, work," she says. "My life here is com-fortable." Yang Li's parents had to survive the Cultural Revolu-tion; her grandparents, the Great Leap Forward. Yang Li has real choices, and she lives in a country where those choices mean something for her quality of life. She tried factory work and de-cided it wasn't for her. Now she says that "I can close the salon whenever I want."

Economics is about Yang Li's choice.



The quotation is from Paul Seabright's book The Company of Strangers (Princeton: Princeton University Press, 2004), 15.

Chapter 1

David Ricardo's account of economic rents is in On the Principles of Political Economy and Taxation (London: John Murray, 1817). The book is available online at: http://www.econlib.org/library/Ricardo/ricP.html. His example of settlers farming different grades of agricultural land is in chapter 2, sections 2.32.5.

John Kay's application of Ricardo's theory to companies is in Foundations of Corporate Success (Oxford: Oxford Paperbacks, 1995).

To find out about the economics of criminal enterprise, see Steven D. Levitt and Sudhir Alladi Venkatesh, "An economic a.n.a.lysis of a drug-selling gang's finances," NBER Working Paper Series 6592 (June 1998), and Thomas Sch.e.l.ling's Choice and Consequence (Cambridge, MA: Harvard University Press, 1984), chapters 7 and 8.

The underlying cost of a cup of coffee is artfully calculated by Brian McMa.n.u.s, "Nonlinear pricing in an oligopoly market-the case of speciality coffee" (working paper, Olin School of Business, Washington University, St. Louis, MO, 2004), http://www.olin.wustl.edu/faculty/mcma.n.u.s/coffee12-04.pdf. The effects of high rents on coffee company profits is explained by Astrid Wentlandt, "Avoiding a coffee has-been," Financial Times, August 7, 2002, 19.

A discussion of, and statistics about, immigration and wages come from Martin Wolf, "A Matter of More Than Economics," Financial Times, April 14, 2004; and George Borjas, "Economics of Migration" (working paper, Kennedy School of Government, Harvard University, Cambridge, MA, 2000).

Other sources for statistics: The number of people pa.s.sing through Waterloo station from Network Rail, http://www.networkrailstations.co.uk/index.cfm?fuseaction=retail.statistics.

Office rents from Insignia, reported in The Economist, April 20, 2002, 116.

Most expensive house in the world from BBC Online News, Sunday, April 11, 2004, http://news.bbc.co.uk/1/hi/england/london/3617861.stm.

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