Institutional Design for China's New Economic Growth Model

Institutional Design for China's New Economic Growth Model Joseph E. Stiglitz Beijing March 2007

Key Elements of New Model • Increasing concern about inequality • Including rural urban divide • Increasing concern about environment • Innovation • Away from export orientation towards domestic consumption and investment

Objectives • Not just an increase in GDP • But sustainable increases in living standards • Environmentally sustainable • Socially sustainable • Better measures (still imperfect) • Measurement affects behavior • Green GDP, median income, HDI • Towards a more “harmonious society” • Between different parts of society • Between economy and environment

New Realities • Growth has not benefited all • Trickle down economics doesn’t work • Even high growth does not ensure jobs • Productivity growth can exceed demand growth • Current trajectory is not environmentally sustainable • Rate of growth of exports not sustainable • Saturation of markets • Political backlash • China has accumulated sufficient reserves to protect itself against fluctuations

Why Export led growth worked • Basis of technological advance • What separates developed from less developed countries is not just disparity in resources but disparity in ideas • Transmission of ideas/knowledge better in industrial sectors (Greenwald-Stiglitz 2006) • Export industries help create standards • Strong competition • Productive capacities expanded more rapidly than capacities to allocate resources domestically • Requiring financial system to make loans and get repayment

Today, China is at a new stage… • Exports are still important • But broad based financial system is rapidly developing • And China has made big strides in technological development • Technological gap reduced, but still there • It has been learning to learn • And is creating the foundations of its own innovation system • China has shown that it can create vibrant competition domestically • But will need to adopt and enforce strong competition laws • Pressure from some vested interests to look other way, allow some monopolies, oligopolies (“big players required to compete in global market”)

Old system was like vendor finance • Selling goods to advanced industrial countries, and in effect lending them money to finance those goods • But why finance richest country in world to consume beyond its means, when there are so many greater needs at home? • Need to promote domestic consumption and investment

Promoting Consumption • excessive savings” as a result of excessively weak social safety net • Providing stronger social safety net would thus be a double benefit • Especially important in health • Improved financial system could also strengthen consumption • Problem is not lending money, but getting it back • That requires strong financial system • Need to continue strengthening • Warning: exploitive financial institutions, combined with bad bankruptcy laws, undermining social harmony

Promoting Investment • Problem today is not so much the level of investment but its efficient allocation • Can be perverse incentives • Short term speculative gains • Or even incentives that may lead to bad investment decisions • Additional revenues for local governments • Additional jobs

Western Technological Developments May Not be Consistent with China’s Social Goals • Pays to much attention to reducing demand for labor • Labor viewed mainly as a cost of production • Implying much effort directed at reducing demand for labor • If productivity grows at say 5%, then output must grow at more than 5% if there is to be any employment growth • From perspective of industrials, higher unemployment has another benefit—downward pressure on wages • Jobs are essential for a harmonious society • Especially when redistributive mechanisms are limited • Reducing demand for labor lowers wages, benefit to firms, but with the consequence of growing inequality

Pays too little attention to reducing the demands on the environment • Market based incentives would help • Carbon tax—makes more sense to tax “bads” than goods (like savings and work) • Could provide needed impetus for a global agreement—around a common tax

Distortions between market incentives and social returns • Market prices don’t reflect social costs (environment, jobs) • Social return of an innovation is its arrival faster than it otherwise would have occurred; private return is monopoly rents that accrue to whoever is first • Innovation is endogenous • Both level and direction • Policies can affect both level and direction • Can have “equality-enhancing” (or even job-inducing) innovations that are at the technological frontier • Trade-offs: reducing environmental inputs and increasing other inputs • Example: retail innovation in U.S. has been land/resource using and labor saving

Examples of implications • Livable cities • Design of innovation system • Design of information system

Livable Cities • Design of cities (urban transportation systems, parks, etc) has major effect on quality of life • Not captured in GDP • Time spent community • Including congestion • Greenhouse gas emissions and other environmental costs • Can have immense effect on “environmental footprint” • Urban amenities

Livable Cities • Decisions today will have long-lived effects • Require government planning (zoning) • Markets by themselves will ignore externalities • And there may even be perverse incentives on the part of markets and some government officials • And cannot solve immense coordination problems

Innovation System • One of central elements in 11th five year plan is the design of institutions for China’s distinctive market economy • Western system has been highly productive • Based on strong government support of basic research • But also highly distorted • Expenditures on marketing/advertising vs. research; direction of research (me-too drugs and life style drugs vs. life-saving drugs; life-saving drugs for rich vs. life-saving drugs for poor) • Monopoly system associated with patents means knowledge is not used efficiently • And in some cases has actually retarded innovation

What is needed is a development oriented intellectual property regime, designed for China’s stage of development • As in other areas, one size fits all policies don’t work • America’s IP system is not good for America • And is even more poorly suited for China • Part of broader institutional infrastructure for the innovation system

Innovation System • Portfolio of instruments—patents, prizes, and government support • With greater incentives for innovation towards social needs (reducing environmental impact, creating employment opportunities) • With greater incentives for using knowledge (using competition) • With greater awareness of the imperfections in the prevalent intellectual property regime • The bias towards patenting rather than keeping ideas in the public domain (it is a public good to challenge a patent) • The adverse effects of monopolization on innovation • The change in the system towards a liability system

Innovation system illustrates several general themes • Institutional structures that are appropriate for one country may not be the best for another • One size fits all doesn’t work • Differences in circumstances, history • Differences in objectives • This is true of property rights system (including intellectual property rights) • Even formulation needs to be changed • Responsibilities as well as rights • Key role of restrictions • These are social constructions that need to be adapted to the circumstances, history, and objectives of each country

Information System • Good information is essential for the running of an economy • Requiring good accounting systems • Appropriate incentives for information revelation • Systems of compensation with stock options provides distorted incentives • Modern economy is highly complex • Governments often don’t have requisite information to make good decisions • Incentives to provide distorted, partial information • Need to develop variety of information channels

Information System • Vibrant, responsible media can play an important role • Needs access to information • Important role of freedom of information acts • Incentives to act responsibly • Balanced libel laws

“Crossing the river by feeling the stones” • Reflects pragmatic spirit that has guided China’s transition • And is partly responsible for the success of that transition

Now that China has gone more than half way across the river, what is on the other side is clearer • There are many forms of a market economy • Japan, Continental Europe, Scandinavia, American, U.K. • And the form of market economy that is sometimes argued for by “free market” advocates is more extreme than that embraced by any market economy • U.S. rejected notion of privatizing social security • Every country has a large variety of restrictions on property rights and imposes large responsibilities on property owners • China can now see that it can make a great deal of difference the directions which it takes • What kind of market economy it chooses will affect what kind of society it will create

Even as China crosses the river by feeling the stones, Creating a Market Economy with Chinese Characteristics that is consistent with China’s distinct circumstances and values will require a New Economic Model • China’s 11th five year plan reflected this New Economic Model • I have tried to lay out some of the economic foundations underlying this New Economic Model

Institutional Design for China's New Economic Growth Model