economics

June 1, 2010

Rent seeking and economic liberalization: why are China and Vietnam different from Eastern Europe?

Filed under: Uncategorized — ktetaichinh @ 8:41 pm
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http://www.viet-studies.info/kinhte/Rent_Seeking_China_Vietnam.pdf
Sachs andWoo (1994) and Sachs et al. (1999) mainly attribute the difference in
reform performance between Eastern Europe and China to the difference in initial
economic conditions. They suggest that China was an agricultural economy at the
start of the reform. Hence China had greater potential than the more industrialized
Eastern Europe to transfer labor from the agricultural sector to the industrial sector,
and to develop a division of labor. As a result, China achieved faster growth. In
contrast, state-owned enterprises in Eastern Europe hired more than 80% of their
labor force that was heavily subsidized by the state. To finance the subsidy, private
sector was heavily taxed. As a consequence, workers were unwilling to leave
their subsidized jobs. There was also no labor reserve outside the SOE sector
that could be hired by the more efficient non-state sector. In such aeconomic growth could not be achieved. The emphasis of these authors on the
initial economic condition is insightful; however, the explanation is incomplete. If
the government keeps subsidies to SOEs constant, or raises the subsidy at a slower
pace than the growth of the private sector, the more efficient private sector will
still be able to attract labor from the state sector, and economic growth will be
sustainable (as is shown by Lau et al. 2000). Hence, to complete the explanation
based on differences in initial economic conditions, we need to know why those
Eastern Europe governments failed to create the conditions that would have made
gradual reform viable, while governments in China and Vietnam succeeded. This
paper aims to answer this question.
Here, I tell a story of government’s dilemma in seeking rent. Following Kornai
(1986), I distinguish two types of economic coordination: bureaucratic coordination
and market coordination. Bureaucratic coordination features a vertical relation
between the coordinating individuals or organizations and the coordinated individuals
or organizations. Control is exerted through administrative coercion and
legal sanctions. In contrast, market coordination features a horizontal relation between
individuals or organizations.2 Mutual and voluntary agreement is essential
for a transaction. The market is dominant in a capitalist economy, and in a socialist
economy bureaucratic coordination is overwhelming. As discussed above,
bureaucratic coordination depends on administrative coercion and legal sanctions,
which generate rents for bureaucrats (Shleifer & Vishny, 1992a).
I assume that the government’s objective is tomaximize its rent. In reality, there
are governments of different agencies and regions and their interests may well be
in conflict. For example, Young (2000) studies how regional governments in China
set up interregional trade barriers while competing for rents. However, I would
argue that as long as the central government has a final say on the reform agenda
and appoints regional officials, the neglect of those inner-government interactions
should not invalidate the assumption that the government as a whole ismaximizing
its rent.Here, I tell a story of government’s dilemma in seeking rent. Following Kornai
(1986), I distinguish two types of economic coordination: bureaucratic coordination
and market coordination. Bureaucratic coordination features a vertical relation
between the coordinating individuals or organizations and the coordinated individuals
or organizations. Control is exerted through administrative coercion and
legal sanctions. In contrast, market coordination features a horizontal relation between
individuals or organizations.2 Mutual and voluntary agreement is essential
for a transaction. The market is dominant in a capitalist economy, and in a socialist
economy bureaucratic coordination is overwhelming. As discussed above,
bureaucratic coordination depends on administrative coercion and legal sanctions,
which generate rents for bureaucrats (Shleifer & Vishny, 1992a).
I assume that the government’s objective is tomaximize its rent. In reality, there
are governments of different agencies and regions and their interests may well be
in conflict. For example, Young (2000) studies how regional governments in China
set up interregional trade barriers while competing for rents. However, I would
argue that as long as the central government has a final say on the reform agenda
and appoints regional officials, the neglect of those inner-government interactions
should not invalidate the assumption that the government as a whole ismaximizing
its rent.
Bureaucratic coordination is economically less efficient than market coordination,
primarily due to two reasons. First, the former is more likely to distort
incentives (Zhang, 1999). Second, resources are misallocated when the central
planning agency is not able to process the large amount of information that is
necessary for effective central planning (Mises, 1922). As a consequence, when
the incentive and information problems are gradually alleviated in a transition
from central planning to market, total output will increase.3 The government’s
loss of control over economic activities undermines its ability to capture rent. As
a consequence, the government loses some rent from the economic sectors where
market coordination replaces bureaucratic coordination. I call this the Type I effect
of economic liberalization. In addition, there is a second effect that is opposite to
the Type I effect. When the market plays a larger role in economic coordination,
output grows; the remaining control power becomes more valuable in a bigger
economy, and this in turn tends to increase the rent for the government. I call this
the Type II effect of economic liberalization. For example, with the opening up of the auto industry, more households can afford to buy family cars. As a result, the
national monopoly of the oil industry becomes more profitable.
Since economic liberalization has two opposite effects on rent, the rent-seeking
government faces a dilemma. The government’s problem is to choose an optimal
level of economic liberalization that maximizes its rent. We show in a simple
model that the government’s optimal choice crucially depends on the initial economic
condition. A gradualist approach is sustainable only when the Type II effect
surpasses the Type I effect. Actually, the model shows that in this situation the rent
and the total output increase hand in hand. In a relatively more developed socialist
economy, the rent captured by the government is already relatively large. When
the economy is liberalized, the Type I effect dominates the Type II effect. Gradual
reform fails in this situation because further reform will reduce the government’s
rent. This analysis explains why gradual transitions are successful in China and
Vietnam, but were not in the Soviet Union, Poland and Hungary, which all tried
gradualist reforms in the 1980s.
Although gradualism could achieve economic growth in the short run, the
model predicts that the path of a rent-induced gradualist transition cannot lead to
a complete market economy. Instead, the transition will be ‘stuck’ in the middle
where further liberalization will reduce the government’s rent. To finish the transition,
the creation of a new constitutional order and rule of law that are able to
constrain the government from rent seeking is necessary.
The paper proceeds as follows. The next section presents the model and its
basic implications. The third section uses the model to examine the transition
process of China. The fourth section concludes the paper.
Gradualism: its past and future in China
There is a long-lasting debate over the relative merits of gradualism versus Big
Bang (Roland, 2000; Sachs & Woo 1997). So far, gradualism has gained more
favor, largely inspired by China’s impressive growth in the last two decades.
However, Sachs et al. (1999) argue that the core of economic transition is a largescale
shift in constitutional rules, and economic transition is only a small part of
the grander transition. In the current model, the value of α
∗ is always less than 0.5
in the model.When a gradual transition process reaches α
∗, the government would
realize that further reform would reduce its rent. Consequently, the government rejects further reform, and the gradual transition will be stuck in the middle. On
the other hand, for those economies that already undergo constitutional transition,
disruption in coordination may make the output plunge in the early stage of reform
(Blanchard and Kremer 1997), but economic growth may be more sustainable in
the long run because constitutional rule is able to restrain the government from
seeking rent and the transition process can be finished.
Compared with Big Bang, gradualist transition gives the government more
time and resources to ‘perfect’ its rent-seeking institutions. Those institutions may
include the system of rank-based rent allocation, mechanisms to compensate the
losers, institutions for internal auditing, punishment, bureaucrats recruiting and
promotion, and so on. In seeking rents, social elites can either join the government
or cooperate with the government. In this scenario, the chance of establishing
constitutional rules and the rule of law is low because no independent social
forces outside the government are able and willing to push for such a change. In
short, a country adopting the gradualist transition approach may very likely be
stuck at state α
∗. In the long run, a Big-Bang approach may be likely to have
superior performance over a gradualist approach.
Since China’s transition is widely viewed as the most successful transition
economy adopting a gradualist approach, and is major evidence in favor of gradualism
over Big Bang, I will apply below the theoretical analysis above to analyze
China’s transition experience. At the start of China’s reform in 1978, China was
an agricultural economy. Bureaucrats controlled most of the economic activities,
especially in the industrial sector. In such a poor economy, even members of the
privileged groups had a poor life, although they were much better off than the
average people. For a specific reform program, some bureaucratic agencies may
become winners and some become losers. The losers tend to impede the reform.
Here comes the key role played by a strong central government. The discipline
and ideology of the communist party require each agency and each region to place
the interests of the whole party at a higher priority than the ‘local’ interests (Gu
Quan Da Ju). The ideology also requires bureaucrats to put collective interest
above individual interest (Collectivism). As the same time, central government
undertook the task of balancing the interests of different agencies and regions.
Although officials of different levels and regions had considerable autonomy, the
central government held absolute final say on the extent of this autonomy.
To boost the morale of the bureaucrats, as well as to keep the bureaucrats
loyal to the central government, privilege and abuse of power are tolerated by the
central government as long as they are within acceptable boundaries.9 As a result,
corruption is widespread. He (1997) documents in detail how bureaucrats in China
accumulate large amounts of wealth through corruption. Nonetheless, the central
government successfully integrated the whole Chinese bureaucratic system in
pursuing its political and economic agenda. Through internal control, the central
government helps alleviate the negative externalities exerted by one agency on
another in their pursuit of rents (Blanchard & Shleifer 2001). In some sense,
the whole bureaucratic system might be viewed as a huge corporation. Although conflicts exist among different departments and units, the top management has
the authority to set rules, align interests, punish those who violate the rules, and
reward those who comply with the rules. As a result, the corporation is a coherent
organization.
By the logic of the model in the second section, an economic sector providing
little rent should more likely be liberalized because the loss of rent is relatively
small. This is exactly the main characteristic of the reform experience in China.
China started the reform in agriculture sector that was the poorest sector in the
whole economy. The reform met little resistance from bureaucrats basically because
the loss in rent was small. In addition, the reform of the agricultural sector
was also carried out earlier in the poorest provinces (such as Anhui province) than
in the relatively rich provinces (such as Jiangsu province).
The productivity of rent seeking depends on the rent seeking technique as well
as the nature of production. In those industries featuring a high degree of increasing
return to scale, rent seeking should be easier. For example, to seek rent through
a national restaurant monopoly is less efficient than through a national banking
monopoly because it is more costly to manage a restaurant monopoly, which has a
very smallminimum efficient production scale. As a result, private enterpriseswere
gradually allowed to enter industries featuring a small efficient production scale
and low capital intensity, while those industries featuring significant increasing
return to scale and high capital-intensity were designated as ‘key’ industries10 and
the entry of private enterprises was effectively prohibited or seriously hindered.
In these ‘key’ industries, government was the major rule maker, major player and
referee. During the reform process, the Chinese government continued to invest
heavily in those key industries (Lardy, 1998, pp. 53–57).
Giving up some control over the economy actually benefits the rent-seeking
government because the remaining power to control becomes more valuable in a
richer economy. By liberalizingmost product markets, theChinese economy grows
rapidly. As a consequence, the government’s control over those key industries
and resources becomes more valuable. A recent study by Murdoch and Sicular
(2000) revealed that the rent captured by the Chinese government bureaucrats
grew steadily during the reform process. The key industries monopolized by
government contain some of the most lucrative enterprises in China. The Chinese
government also controls all the natural resources. In recent years, with a rapidly
growing economy, the land market becomes a major revenue source for regional
governments. Owing to the large amount of rent, government has little intention to
open up those ‘key’ industries and privatize land ownership. China also made slow
progress in the rule of law. The court system is virtually a branch of the government.
As a result, courts cannot effectively enforce the law. The encroachment of private
property is widespread. Protection from affiliated officials is the essence for the
success of most private enterprises.
What is the future of Chinese-style gradualism? According to themodel, China
started its journey from the origin and is heading for α
∗, as in Figure 3. During the
past two decades, the degree of economic liberalization, total output and rent have all increased. However, when the transition process reaches α
∗, further economic
liberalization will cause a divergence between output and rent: output would grow
but rent would not. A rent seeking government may stop the liberalization process.
Conclusion
Two conditions contributed to China and Vietnam’s so far successful gradual transition
to market economy. First, the two countries were low-income, agricultural
economies at the start of the transition. By liberalizing the economy, although the
government lost some rents, the total rent still grew because the remaining power
to control became more valuable in a growing economy. Second, both China and
Vietnam have strong central governments, which are able to alleviate the externalities
caused by one bureaucracy on another in rent seeking. Without this control
from the central government, agencies may have tried to extract rents from the
private sector in a more abusive and arbitrary way, making it unprofitable to run
private enterprise. As a result, gradual reform would not be able to generate economic
growth. This is consistent with the view of Blanchard and Shleifer (2001)
that political centralization is an important reason behind China’s superior performance
to Russia. Due to a lack of the second condition, gradual reform that was
tried in some post-socialism countries (for example, Ukraine) also generated an
unsatisfactory outcome. This paper suggests that rent-induced economic transition
cannot reach a complete market economy because the transition will stop at a
turning point where further loosening of government control will reduce the rent.
In the long run, the success of economic transition needs a foundation of
constitutional rule, which is able to restrain government from seeking rent. The
transition from arbitrary government control to constitutional rule may be more
unpredictable and difficult than economic transitions.Old institutions may collapse
suddenly and the new institutions may not have enough time to be established. For
example, in Indonesia, corruption in the post-Suharto era has been more problematic
for investors than it was before.11 Further understanding of the institutional
transition process may be necessary.

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