Economist Lin Yifu on State-Sustained Growth

Standing up to a wave of pessimism about China’s prospects for continuing high-level economic growth is no easy task.

But economist Lin Yifu, who recently retired as a senior vice president and chief economist at the World Bank, is holding his ground with a prediction that China’s gross domestic product will grow by 8 percent in 2012.

Underpinning Lin’s sometimes controversial position is what he calls “new structural economics”—a theoretical framework that emphasizes the importance of a state role in shaping and directing an economy.

Lin says he doesn’t mind stirring controversy or clashing with the pessimists as long as he is allowed, as he says, to “engage in deep discussion and not just stay on the emotional surface.”

Lin made this and other comments August 24 during an interview with Caixin in which he explained his theory of structural economics and recommended government policies that could benefit China well into its next stage of economic development.

Since graduating with a doctorate from the University of Chicago in 1986, Lin has focused on integrating modern economic theory with his homeland’s real-life challenges. His has been a quest for the most suitable development strategy for China.

Among the critics of Lin’s structural economics theory are those who think the Chinese government’s participation in the economy has already gone too far. But in fact, he argues, the state will and should always participate in economic activities. So what’s needed are formulas for maximizing the positive effects of government involvement and minimize what’s bad.

China’s economy can continue growing at relatively high rates, Lin says, as long as the government plays a positive role by leaning on what’s been called the nation’s “two-track system” of fast and stable GDP growth.

Lin thinks China has to adjust its development model in light of changes in the economy’s comparative advantages, such as its ability to keep wages low in the manufacturing sector, promote technological innovation, and move up the industrial development ladder.

None of these steps are easy. But Lin is standing his ground as an optimist for rapid growth—an optimism seen through a realistic lens and underscored by his Caixin interview, which follows.

Caixin: What is the theoretical framework for the “new structural economics,” and how is it connected to your previous work on a theory of comparative advantages?

Lin: New structural economics involves a deeper inquiry into the essence of modern economic growth. Adam Smith’s Wealth of Nations explored the nature and origin of national wealth. Economists should explore the nature and origin of issues they are studying, rather than simply research existing theories.

A nation’s factor endowments determine its industrial structure. As factor endowments change, technological innovation occurs and an industrial structure improves. This is the essence of modern economic growth.

Because endowment structure differs from one country to the next, differences can be found in the areas of opportunity costs and budget constraints, as well as technological and industrial capabilities. The institutional and infrastructure requirements for supporting an economy—including roads, ports, electricity, education, legal systems, financial systems, etc.—also vary.

I have proposed analyses of industrial structure and development policies based on the micro-foundation of a firm’s production capabilities.

New structural economics and the theory of comparative advantages are closely inter-related. The best way to upgrade a nation’s endowment structure at any given moment is to develop an industry in line with the comparative advantages provided by the existing endowment structure. Sustainable economic development is achieved by continuing to transform factor endowments, along with accompanying technological and industrial innovation.

New structural economics also offers a better explanation of the interactions between infrastructure, both “hard” and “soft,” and the real economy. If there are no improvements in infrastructure, transaction costs increase, inhibiting development of the real economy.

At the same time, the economy of a country that slowly climbs up the industrial ladder witnesses changing infrastructure requirements. There is no such thing as optimal infrastructure; what matters is to best meet the needs of an economy at any particular stage of development.

Caixin: What roles do the government and market play in the process of economic transformation and in upgrading industrial activity?

Lin: Both play important roles. To make private companies willing to operate in industries that have comparative advantages, relative factor prices must reflect a relative degree of scarcity, which can only be determined by competition in a well-functioning market. Therefore, the market should be the basis for a modern economic system. This is the main difference between new structural economics and the first-wave theory of development economics.

Yet during the process of upgrading an industrial structure and forging technological innovation, the invisible hand of the market cannot resolve problems connected to information asymmetry, negative externalities, and coordination issues. Therefore, the government must play an active role: This is where new structural economics differs from the “Washington consensus.”

Caixin: A lot of people are cautious about government intervention. Why does new structural economics particularly emphasize the role of government?

Lin: It does not put particular emphasis on the government’s role but simply states that both government and the market have rightful places. Some feel new structural economics puts particular emphasis on government because it contrasts with the Washington consensus with which people have become accustomed.

Caixin: According to your theory, what role should the government play in the industrial upgrading process?

Lin: As the endowment structure of an economy changes, so will its potential comparative advantages. A government and enterprises lack information about which industry might benefit from a new comparative advantage. Based on historical experience, though, governments in developed and developing countries will intervene during the technological innovation and industrial upgrading processes. The only differences are in their means of intervention.

Government must encourage innovation through four common measures: support basic research, protect patents, mandate the use of new technologies and products, and government procurement. Of these measures, only patent protection does not require government decision-making.

Mandatory use requires explicit choices by the government of what technology to support. The other measures are limited by a government’s budget.

The view that developing countries do not engage in industrial intervention certainly does not reflect reality. A government may not make the right choice, but its decisions are not necessarily worse than those of private firms because the government has more experts at its disposal.

Caixin: So where are the limits of government encouragement? Some worry it can easily become excessive.

Lin: Certainly, there is a problem with too much government help, which can be worse than not enough. This can include supporting non-viable industries that will never be self-sufficient.

In principle, then, government must focus on industries with the potential for comparative advantages and help them with information gathering and coordination, in order to reduce pioneering companies’ risks. The government is a midwife for new industry, not a permanent nanny.

Pioneers must be given subsidies within restricted timeframes and fiscal limits that should generally be short-term or one-off. Government intervention can only yield positive results if applied to industries with comparative advantages, so it need not—and should not—be twisted through monopolies, high tariffs, etc.

In the past, these levers were often used by governments to support industries that were not viably self-sufficient on the open market, violating a rule of competitive advantages. These distortions led to rent-seeking.

Caixin: After more than thirty years of development, China’s factor endowment has changed dramatically. Many worry that as the cheap labor advantage gradually disappears, China is at risk of slipping into the “middle-income country trap.” What should be China’s next step?

Lin: As factor endowment improves, capital that used to be relatively scarce becomes relatively abundant, and labor that used to be relatively abundant becomes relatively scarce. Old comparative advantages disappear. This is a necessary result of economic development, and a necessary mechanism for increasing income. The key to whether China slips into a middle-income trap is whether industrial and technological structures can upgrade vis-à-vis changing factor endowment. Structural adjustment is a long-lasting issue in developing and developed countries as well.

Middle-income countries are unlike low-income countries in that some of their industries are world leaders in areas from which developed countries retreated. These industries need technological innovation, so the government can play the same role that was played by governments in developed countries. It needs to support basic research and patent protection, as well as set timetables for adopting new technologies and new products and, finally, government procurement.

Caixin: China is indeed calling for a transformation of its economic growth model. But how?

Lin: The key in this process is to shift from an unrealistic strategy which is not suitable for China at its current stage of development to a comparative advantages-based strategy.

Two things must be done: First, remaining problems associated with the old two-track system must be resolved. Second, the very idea of development must be changed.

Back in the old days, the two-track system helped China reach its twin goals of stable and fast growth during an economic transformation. But it’s time for mechanisms designed to protect unsustainable companies to go. These mechanisms include financial market’s heavy dependence on large banks and the stock market, non-market-oriented pricing system, resource taxes that are too low, and monopolies in certain sectors.

Caixin: One of the elephants in the room here is the reform of industrial monopolies. Many suggest China should open up these monopolies to the private sector. What’s your take?

Lin: The key is to return to the essence of the problem, rather than analyze ideology. For monopolies in industries with scarce resources, whether they are state-owned or private, the same problems stand. The key is to reinforce regulation.

For competitive industries in which large companies are major players, the key is to loosen requirements on market entrance and encourage fair competition. It must be emphasized that all current theories deeming private ownership better than state control hinge on recognition that the owner should also be the manager. In fact, this is never possible for large companies. There’s no reason why a manager who manages a company on behalf of private shareholders is necessarily better than a state manager who does so on behalf of citizens. So what’s most important are fair competition and survival of the fittest.

For mid-sized or small companies, the management and ownership can be the same. So of course, private companies are better.

I think state management is better than private ownership for firms without comparative advantages that exist for national defense reasons. Because they can’t survive on their own, protective subsidies are necessary. From both theoretical analyses and the practical lessons of Russia, private firms require more subsidies from the state. The United States also has national defense companies that, although private, still have the same problems. That’s why in most countries, including Europe, national defense companies are state-operated.

Caixin: China’s reform process has waded into the deep-end of the pool. Many experts say there’s been little progress for reforms proposed to remedy some remaining problems because of resistance from vested interests. How do you see this?

Lin: Vested interests have always existed. The vested interests we have today aren’t more powerful than those that existed during the early stages of China’s economic reform. At that time, there were eight ministers on the State Council from heavy industry alone, and rural commune directors were like emperors of their own little kingdoms.

As long as the government thinks problems through and keeps a clear head in terms of which reforms are good for stability and development, and which would hinder China’s progress, I believe it will actively promote those that are good.

According to recent news reports, some remaining issues with the two-track system such as over-centralization of the financial sector, resource taxes that are too low, market entrance for monopolized industries, and income distribution will be dealt with during the 18th Party Congress.

Caixin: Government intervention may also bring a lot of negative effects, such as those that came with the 4 trillion yuan stimulus package. What’s your opinion?

Lin: There was some domestic opposition to the stimulus package. But if not for government intervention, 20 million migrant rural workers could have been unemployed and we could have witnessed a sharp economic decline. Surely, that would have been much worse.

Many people object to the fact that many state-owned enterprises went into real estate, which is a realm for the private sector. As macroeconomic control was largely comprised of monetary policies, only about 1.2 trillion yuan of the 4 trillion yuan in stimulus came out of the government budget. Most of the rest came from bank loans whose flows weren’t easy to control. It’s easier for state-owned enterprises than private companies to get these loans. This is a long-standing financial structure problem, not one of macroeconomic control per se.

Caixin: The previous stimulus round raised government debt and caused excessive infrastructure investment. Many of these investments may never see a return. So is there still room for fiscal policies?

Lin: Current government debt, including what’s on the books at local government financing platforms, only accounts for 40 percent of GDP, a comparatively low percentage compared to government debt levels in other parts of the world.

Whether projects launched after the previous round of stimulus are good or bad will depend on China’s growth. If we can maintain 8 percent growth, then lots of those projects will be good. If growth is allowed to fall to 3 percent, many would be bad.

Promoting a positive fiscal policy will necessarily lead to higher government debt. But effective investments create jobs and demand immediately, and growth in the future, which again brings in more government revenue that can be used to pay off debt. I call this Keynesianism with foresight.

Caixin: So how should we describe the current decline in growth?

Lin: I think it’s cyclical. It is first a result of reduced foreign demand, as the United States and Europe have yet to come out of the crisis. Second, it’s due to lowered domestic investment demand. Most of the projects of the last round of stimulus have been completed. If we don’t keep up with investment, demand will certainly fall. To deal with structural problems, we will forever have to adjust the economic structure by implementing adequate measures.

Caixin: What’s reasonable growth for China?

Lin: The current growth model is not only unsustainable, but it doesn’t create jobs. It will eventually lead to frequent crises. Growth by relative advantage is sustainable and will create more jobs; certainly, the faster the better.

The central government is more interested in employment. Job creation not only depends on the speed of growth, but it is also related, to a great degree, on the mode of growth. Developing by relative advantages creates more jobs.

Local governments are more interested in the speed of growth because that is what’s on a governor’s report card. But local governments tend to develop this way due to the distorted environment.

In addition, those that think low growth rates can stimulate reforms completely miss the point. Low growth will create more social and political problems, which makes reform even harder. Many countries in Latin America, North Africa, and the Middle East have growth rates below China’s, but in many necessary reforms have not been implemented. So growth rates and reform are not related.

We must study the essence of a problem. It’s easier to solve problems when there is rapid growth.

Ye Weiqiang and Huo Kan are Caixin staff reporters.