Economic Reform: Success in China and Failure in Eastern Europe
Ross, John, Monthly Review
Since Russia, the other countries of Eastern Europe, and China had quite similar economies under their communist governments, any analysis of Russia's current economic crisis must eventually ask why the economic reforms in China since 1979 have produced the greatest economic success of recent times and the structural changes in Eastern Europe since 1989 and in Russia since January 1992 have produced such disasters. This is not an academic question; these disasters affect hundreds of millions of people. As the UN Economic Survey of Europe in 1992 notes, "The cumulative drop of output registered over the last two to three years in some countries has attained proportions that are unmatched even by the Great Depression of 1929--1933." Russia in 1992 has suffered the greatest peacetime decline in ia modern history. The fact that the course of reform it followed has produced disaster in every country in which it has been applied shows conclusively that the failure lies not in particular errors of application but in the nature of the policies themselves. It is these processes which underlie the deepening political crisis in Russia.
The contrast between the results that followed the Chinese reforms in 1979 and those that followed the East European reforms in 1989 illustrates the differences dramatically.
In the decade after the 1979 reforms, Chinese gross domestic product grew 135 percent. The growth trend picked up immediately after 1979 and continued essentially unabated. In Eastern Europe, the immediate effect of the 1989 reforms was a sharp decline in output that has persisted until the present. China demonstrably made the kind of change that Russia now requires. Consumer goods became the leading sector of the economy, the supply of high quality foodstuffs such as fruit and meat increased enormously, the service sector expanded rapidly, small-scale enterprise flourished, the productivity of labor and investment both soared, and living standards doubled. The Russian government has proclaimed these goals, but so far it has completely failed to achieve them.
The contrast is not, of course, accidental. The same "laws of economics" that led to success in China have dictated failure in Russia and Eastern Europe. The mistake of the governments in the latter countries has been to misunderstand the specific character of the Russian economy and those modelled after it. They are altogether different from the competitive economies of the West. Russia, Eastern Europe, and China are "dual economies". Such economies have a large and almost-pure monopoly sector that operates essentially according to the laws of monopoly, and a non- monopoly sector that operates essentially according to the laws of competition. The specific dynamic of economies of this type results from the interaction of the two sectors. Once the character of these economies is understood, then their laws and the policies necessary for them to function successfully are clearly defined.
The National and International Markets
To evaluate alternative growth policies for a country like Russia, with its dual economy, it is essential to consider both the relative sizes of its national and international markets and the structural differences between them. The world market is essentially competitive. Except for a small number of commodities, no one country dominates supply. But the Russian domestic market is part of a dual economy, made up of monopoly sectors and competitive sectors. If the world market dominated the supply side of the Russian economy, one could still say that Russia had an essentially competitive economy, which would therefore be governed by the laws of competition. But since the domestic market is dominant, the Russian economy is subject to the laws of the dual economy. The Russian government and the people advising it fail to grasp the significance of this. They fail to draw the necessary conclusions from the fact that Russia itself and the other former Soviet republics are its dominant sources of supply. According to IMF calculations, Russian trade is about 22 percent of GDP. Of this 22 percent, however, 13 percent is with other areas of the former USSR, leaving only a little more than 9 percent as "external" in a genuine sense. The predominance of trade with the former Soviet republics is highly significant because the USSR was integrated riot simply in terms of the market for final goods but also in terms of raw materials and intermediate goods. For this reason, it is this "domestic" market which is decisive in assessing the relative importance of competition and monopoly.
The Dual Economy and Inflation
The difference between Russian and Western industrial structure is striking. In the former USSR, 87 percent of the nearly 6000 products delivered to the State Supply Commission in the machine- building industry came from single sites. Some 30--40 percent of industrial products came from single producers. Enterprises with more than 1,250 employees accounted for 85 percent of industrial employment. Both final assembly and components supply are monopolized. Similar structures exist in Eastern Europe and China. In the West, enterprises with more than 1,000 workers account for only 20 to 33 percent of employment. Even in the extremely concentrated and capital-intensive semiconductor industry in Japan, for example, the top five firms account for only about 60 percent of production.
The industrial sphere of the Russian economy is closer to a perfect monopoly than anything in the West. Moreover, the government's hopes that privatization and international competition can offset the effects of monopolization are illusory. The monopolization exists at the level of production, not simply at the level of ownership, and therefore privatization in itself will do nothing to ameliorate it. Moreover, Russian exports are so small they cannot finance the imports necessary to make the domestic markets competitive, and are likely to remain small.
The laws of monopoly are well known, and have often been used by Russian economists to point out the errors of the government's policies. In the former Soviet system the monopolies produced to meet planning targets, and since they were subject to price controls, they could in any case have increased profits only by increasing output, not by restricting it. But with the transition to "free markets," the best strategy for the monopolies which have been released from government control is to reduce output and raise prices to the point of profit maximization. This has in fact been done in Russia and Eastern Europe, and by itself explains a large part of the economic decline.
The direct effects of monopolization are reinforced by the dynamics of the credit system. The monetary authorities recognize that monopoly price increases will follow the spread of the free market and that this will put them in a bind. Either they must permit general inflation by increasing the money supply in proportion to the price increases, or they must "lean against the wind" and permit output to decline. The Poles pursued this latter strategy at the end of 1989, when they reduced the rate of growth of the money supply from 190 percent in the third quarter of the year to under 10 percent in the second quarter of 1990 in the face of a 400 percent rate of increase in domestic prices. The result was precipitous drop in the "real money supply" and a disastrous collapse in output.
When Russian industry and trade unions jointly called for credit expansion in the summer of 1992, their call was therefore justified. But credit expansion creates problems peculiar to the dual economy. While an increase in the money supply is necessary to prevent the collapse of output in a heavily monopolized economy suffering from inflation, such a measure just permits the inflation to continue. Prices in the monopoly sector rise relative to those in the competitive (largely agricultural) sector, whose individual enterprises cannot gain from cutting production. Their input costs rise relative to their output prices. The monopoly sector also gains preferential access to credit. This makes the crisis in agriculture (and other competitive sectors) more profound than the crisis in industry. Full "liberalization" of prices has been disastrous for small private enterprises, and about 50 percent of the cooperatives in Russia have gone bankrupt.
This particular dynamic would not be so decisive if the Soviet Union had not deliberately underdeveloped its consumption-goods industries. The degree of this underdevelopment is at the core of the difference between economic success in China and disaster in the countries of the former Soviet bloc. Well under 55 percent of Soviet GDP, probably under 50 percent had been devoted to the production of consumer goods, compared to 60-65 percent in most western countries and 67 percent in the United States. This underdevelopment not only undermined the incentive to work, but led to serious distortions in the structure of productive capacity from the perspective both of domestic needs and of international competitiveness. Moreover, the Soviets further undermined worker incentives by allocating much less to housing than the people would have chosen if their needs had carried more weight. In the West, the share of investment devoted to building housing is normally in the range of 23-33 percent. In the Soviet Union during the years 1971-89 it was only about 15 percent. The service industries, which are among the most rapidly-growing in the economies of the West, were underdeveloped as well. In 1990, employment in services was 57 percent of the civilian tool in Germany, 59 percent in Japan, 71 percent in the U.S., but only 45 percent in the Soviet Union.
Thus, at the time of privatization, by comparison with the West the Russian economy was relatively overdeveloped in the direction of heavy industry and underdeveloped in light industry and services. This industrial imbalance was paralleled in the degree of industrial concentration, with high concentration dominant in the overdeveloped industries and lower concentration in the industries that were underdeveloped. When the process of price determination was "liberalized," relative prices shifted in favor of the monopoly sector and squeezed the less concentrated industries mercilessly. Such perverse changes rewarded the overdeveloped industries and crushed the underdeveloped, running precisely counter to what was needed to make the market respond to the needs of the people.
The Chinese Economic Reforms
No significant part of the monopoly sector was privatized in the course of the Chinese reforms. There were several waves of "small privatization," particularly in retailing, but these had no effect on large-scale industry. Output in the monopoly sector was expanded by three complementary mechanisms. (1) The entire economy was expanded very fast under the impact of policies discussed below. The demand for goods from the state industries was therefore maintained at a high level. (2) Slightly less than half the investment in the state sector was subject to a central plan, and from 1978 to 1988 it only declined from 8.7 percent of GNP to 7.5 percent. (3) Large amounts of state credit were advanced to enterprises; such credits increased from about 9 percent of GNP in 1978 to about 30 percent in 1988. However, because prices were controlled in the monopoly sector, the monopoly enterprises could only increase their profits by increasing output.
This combination of high demand and cheap investment credits led to rapid expansion in the output of the state enterprises. Gross output in the state-enterprise sector rose by 56 percent from 1981 to 1986, at an annual rate of nearly 10 percent. Therefore the change in industrial concentration that took place over this period came about not because the state sector was curtailed or privatized, but because other sectors expanded more rapidly. The gross industrial output of the non-state collective sector increased at a rate of about 19 percent per year over the same period. Thus China did not destroy its state monopoly sector but altered its relationship to the rest of its economy.
On the demand side, the foundation of the Chinese economic reform was a radical increase in the share of national income that was passed down as personal income. From 1978 to 1981, in only three years, the share of GNP devoted to private consumption was increased from 52.6 percent to 58.5 percent. In real terms, consumption increased by 20 percent. All other goals were subordinated to achieving this leap. Government consumption was reduced from 14.2 percent of GNP to 11.5 percent, and fixed investment temporarily reduced from 26.8 percent to 20.1 ;percent of GNP, although it was restored after the jump to a higher level of consumption had been achieved.
This huge shift in the share of output devoted to consumption was the precondition of the transformation of the supply side. New industries--processed foods, household durables, and consumer services--could only develop if a market were created. But the transformation was not carried out in reckless haste, as in Russia. The drop in the share of output devoted to the military was the chief means by which consumption standards were raised, but the 3 percentage points by which military production fell as a share of output was spread out over ten years.
The restructuring of supply required by the change in the structure of demand was accomplished by 2L Urge change in relative prices in favor of the non-monopoly sectors of the economy. This mechanism was the key to the success of the economic reform. In 1978-81, with the start of the rural reform, the procurement price of agricultural goods was raised by 38 percent relative to the prices of industrial goods, and the prices of consumer goods rose 11 percent relative to the price level as a whole. In 1984-86, with the start of the urban reform, the prices of consumer goods rose relatively by another 11 percent. The incomes of the populace were protected against these price increases by subsidies and wage increases. Unlike the Russians, therefore, the Chinese consumers did not suffer from the change in relative prices and benefitted greatly from the increased supply of consumer goods, so the measures were widely supported.
Since the boundary between investment and consumer goods industries largely corresponds to that between the monopoly and non-monopoly sectors, the restructuring of prices amounted to a shift in favor of the non-monopoly sector, the exact opposite of what took place in Russia. As all barriers to production for the consumer markets were removed and prices took this very favorable turn, the enterprises in agriculture and other consumer-oriented industries flourished. The price reform thus gave genuine substance to the right to establish private enterprises, whereas in Eastern Europe the legal right was largely nullified by unfavorable prices.
In China three distinct industrial sectors were developed. The private sector remained small, producing only 5 percent of industrial output in 1989. The collective sector, made up of groups that leased facilities from municipalities and of groups with their own facilities, produced 36 percent of industrial output in 1989. The state sector produced 56 percent. Throughout the decade of the 1980s the collective sector grew relative to the state sector.
Employment in the services industry exploded. From 1978 to 1988, total employment in China increased by 35 percent, but employment in food preparation went up by 327 percent, in retailing by 389 percent, and in other services by 750 percent. Total employment in these three sectors increased from 6 million to 30 million.
Agriculture was decollectivized. Land remained the property of the nation, but responsibility for production passed to family farming units. Essentially perfect competition was established on the supply side of the market. On the demand side, a system of incentives was created in which the state pledged to purchase a quota at a fixed price and anything beyond this at a higher price. These incentives were strengthened by successive price increases. The effects on production were what one might expect. Between 1980 and 1984 food output increased by 6.9 percent a year, cereals production by 7.4 percent. By 1984 the fundamental problem of the basic food supply was solved, the uptrend in procurement prices was brought to a halt, and attention was shifted to increasing the output of higher quality food products such as meat, vegetables, and sugar.
The interaction between the rural and urban sectors created a huge demand for consumer goods. Total industrial output grew by 8.6 percent a year from 1979 to 1984, but production of refrigerators grew by 47 percent a year and of television sets by 98 percent a year. After 1984, procurement price increases were brought to a halt, and growth in agricultural output slowed to 5 percent a year, but the rate of industrial growth rose to 14.5 percent. By 1988 China was producing 7.6 million refrigerators and 25 million television sets. A housing boom was under way. It was this successful consumer market which laid the basis for the continued rapid economic growth of the early 1990s and the recognition of China as the emerging economic superpower of the next century.
The Challenge to the Russians
The strategy that enabled China to make this progress was essentially the opposite of what failed in Eastern Europe and Russia. In the latter countries, the state abandoned its control over the monopoly industries. Output in the monopoly sector collapsed, monopolies raised their prices relative to prices in the competitive sector, and the latter sector was impoverished by the higher prices. But in China the government used its direct control to maintain or increase output in the monopoly sector and its control over prices to encourage the development of the competitive sector. It is clear from the laws of development of the dual economy that only a reform of the Chinese type can succeed in Russia. No matter how long an "East European" reform is given to work itself out, there will be nothing but disaster. There is no known administrative mechanism that can possibly create the complex network of non-monopoly enterprises necessary to supply consumers in a modern society. The state must take the lead, but it must use the market mechanism to develop the consumption goods industry at all levels, from production to retail distribution.
Three substantial interest groups in Russia clearly have an incentive to promote reforms of the Chinese type in their own country and have enough influence to make their voices heard at some level of government: (1) industrialists and managers, who know they must somehow halt the destruction of industry and create the conditions that will make economic modernization possible; (2) representatives of the working masses, notably the trade unions, who see the absolute necessity of turning around the decline in employment and consumption; (3) small businessmen, for whom newly- won legal rights are a mockery in an economic climate in which they cannot survive. There exists therefore the political basis for a reform movement of a different type, and the disasters of the current policies are there for all to see. We shall see whether these forces are capable of forming a coherent economic and political bloc. If they do not, the deepening economic chaos will strengthen still further the extremist nationalist forces reflected in the vote for Zhirinovsky at the recent elections.
John Ross is the economic advisor to Ken Livingston, a Labor Party MP in the British Parliament. He has been living in Moscow for much of the past two years.…
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Publication information: Article title: Economic Reform: Success in China and Failure in Eastern Europe. Contributors: Ross, John - Author. Magazine title: Monthly Review. Volume: 46. Issue: 1 Publication date: May 1994. Page number: 19+. © 1999 Monthly Review Foundation, Inc. COPYRIGHT 1994 Gale Group.
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