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Breaking the cycle: Chinese governance and economic fluctuation
Enzio von Pfeil , China Brief of Jamestown Foundation
8/1/2004

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China's "overheating" economy has commanded a great deal of concern in recent months. Indeed, some have suggested that if the Chinese economy "cools" too rapidly, world economic stability may be at risk. While such observations are not to be dismissed out of hand, they overlook a deeper point regarding economics and politics in China. Boom and bust cycles represent merely the symptom of imbalanced governance structures. China is destined to continue with these boom and bust cycle until its political structures of governance have been settled.

Before discussing China's structural issues, however, it may be useful to reflect on the causes for booms and busts in Western economic history. Prior to John Menard Keynes' demonstration of the efficacy of fiscal policy in dampening economic highs and lows, periods of expansion and contraction occurred with some regularity and to varying degrees of intensity. When the economy headed south, no mechanism existed to prevent its withering, with all of the horrible social and political consequences which followed. Equally, when the economy headed north, it "overheated": there were no brakes here, either. Keynes showed that counter-cyclical fiscal policy could act as a buffer against such swings. Implementing certain fiscal policies removed (or at least curtailed) the structural causes of the boom and bust cycle.

Milton Friedman achieved similar successes in making monetary policy a crucial tool for economic policy. In the more popular economic literature, he is perhaps best known for marketing the "quantity theory of money," which at its simplest states that too much money breeds inflation. Analysis of the pre-Friedman years gives evidence of inflation occurring when too much money is in circulation. Until policy makers accepted the quantity theory, boom to bust cycles persisted as a result of too much money chasing too many goods. With the acceptance of the quantity theory, the violent inflationary swings have for the most part been curbed. Not dissimilarly, Professor von Hayek's ideas on limited government and free markets stemmed the socialist tide in the UK and U.S., allowing new businesses to flourish on a structural basis through out the 1980s and 1990s.

Keynes, Friedman and von Hayek illustrate the extent to which the political/governance structures of a system impact economic developments. By analyzing the structures within the Chinese system, we can begin to understand more clearly the reasons for its economic fluctuations. [1] Prof. Kenneth Lieberthal's Governing China (W. W. Norton & Company, 1995) provides a useful point of departure for such an analysis.

The issues facing Chinese structures of governance in general must first be addressed so as to put into context questions of economic variations. The most pertinent of these issues remains the autonomy of the provinces and major metropolises, such as Beijing, Shanghai, and Tianjin. These political-economic entities maintain the rank of Ministry within Beijing. As a result, no Beijing Ministry can issue binding orders to any province.

For example, the State Council recently issued an 11-point decree on the Ministry of Construction's website which attempts to lessen tensions between homeowners, developers and the government. [2] However, while the Council may well be China's de facto cabinet, with various commissions and ministries subordinate to it, it has little power actually to enforce its demands. As we have pointed out, provinces have Ministerial rank – and thus are not subordinate to orders from other Ministries or from the State Council. The hydroelectric dam project in the Yunnan Province similarly illustrates this clash of authorities. [3] At the time that this article appeared, Premier Wen Jiabao ordered work on the project to halt until after the completion of an impact assessment. Yunnan's provincial bosses, however, approved the project to help alleviate regional poverty, demonstrating the lack of clear lines of authority. A final and striking example appeared recently in The South China Morning Post. [4] In an effort to assert its authority over municipal land sales in Beijing, the Central government would like to require that all future land sales be approved by its Ministry of Land and Natural Resources. Given Beijing's Ministerial rank, however, it remains to be seen whether the Central government will be able to assert its authority in the very city in which it is located.

What do these examples have to do with China's economic boom and bust cycle? Simply put, without a central authority with the ability to impose its agenda on regional and metropolitan authorities, these entities will continue to follow their local interests, thereby derailing any attempts at a unified national policy. The issue of center versus periphery brings to the fore another topic of debate: centralization versus decentralization. In China, the tug of war between localities/provinces and center has not been resolved, and remains a major hindrance to the effective implementation of sound fiscal policy.

A second structural hurdle that stands in the way of mediating China's boom-bust cycles is the ultimate authority of the Chinese Communist Party (CCP). The CCP's ultimate control over all aspects of governance practically inhibits the control of professionals over their area of expertise. For instance, in the case of the Yunnan dam project, members of the Nuking Communist Party Committee support continued construction. However, the extent to which these individuals have training in issues such as environmental planning, engineering, or economics is questionable. Moreover, party bosses have a very different agenda from professionals. By building the dam, party officials hope to alleviate regional poverty. An economist who thinks the dam would create bubbles of economic prosperity that would ultimately be detrimental to the overall economy would have no authority over local party bosses when it came to curtailing the project.

A final structure fueling boom-bust cycles is the lack of clear lines of responsibility. Lieberthal calls this "matrix muddle." A prime example would be the Ministerial rank of the provinces and certain cities. Directives from the Central Ministry in Beijing must compete for authority over issues with the interests of local/provincial governors. When we add to this authority overlap the power of Party officials, the decision-making system becomes quite byzantine. When we finally consider the fact that the political system duplicates itself at all territorial levels – from province to county to city to danwei (local unit) – any one person may have several different bosses. Depending on one's allies and enemies, different decisions can be made by different people for different reasons.

Without a clear chain of command and clear lines for the division of authority, policies cannot be implemented in a coherent and total fashion. By way of contrast, the United States Trade Representative (USTR) handles all matters relating to American trade policy. While other trade organs "feed" their views into the USTR office, the U.S. Trade Representative is ultimately in charge of all trade matters. These matters are his responsibility. And again, while political appointees (whose qualifications may not necessarily be technically sound) run the U.S. Treasury, a marvelous wealth of technical talent exists within the department. China lacks a governance structure where a single entity has responsibility for decision making with regard to some issue. Nor does the decision-making within China's governance structures emanate from technically competent individuals.

Keynes, Friedman and von Hayek each struggled with a structural cause of global boom-bust. And each countered cyclical economic fluctuations with fiscal policies designed to change the existing political/governance structures. The result has been a Western capitalist world which is less susceptible to the horrible violence of boom-bust cycles. Until China grapples with its own structural inadequacies, it will not be able to stop the reoccurrence of massive boom-bust cycles. This would only lead to worsening social tensions on the mainland and may even threaten the leadership in Beijing.

Notes:
1. Of course, there are other causes, such as the lack of rule of law, insufficient creditor rights and other weaknesses in China's bankruptcy laws. Readers are referred to a recently published paper by the Asian Development Bank on this topic.
2. "End ‘uncivilized' eviction of homeowners, Beijing demands," The South China Morning Post, June 16, 2004.
3. "Dam work continues despite directive," The South China Morning Post, May 19, 2004.
4. "State to approve capital's land sales," The South China Morning Post, June 18, 2004.

*Mr. von Pfeil is chairman and CEO of Commercial Economics in Hong Kong.


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