The Economics of Mao’s China

Planning and Markets

Michael Smitka

Washington & Lee University

Economics 274, Spring 2004

Overview

• Genesis of Planned Economy

• Logic of Formal Planning

• Problems and politics of planning

• Price Reform– Agriculture First– Dual Track System

• Remaining issues– SOE reform - including pensions

– Financial sector reform

Logic of Formal Planning

• Genesis– USSR outperformed the US, Europe and Japan:

1930-1950– KMT (Kuomintang “Nationalists”): Chiang

Kai-shek trained in Moscow, had already nationalized industry!

• Socialist ideology of state ownership– Inequitable, plus Instability, Inappropriate

output.– Plus belief in economies of scale, modern

management

Formal Process

• Put major productive resources under State control

• Manage through “Five-Year Plan” with annual increments & targets

• Materials Balance– Calculate inputs needed to obtain target output– Iterate to get consistent & feasible plan– Set up accounting to handle residual market

transactions; money otherwise irrelevant

Contrasts of plan and market

• Role of Markets– Emphasis on physical quantities - prices are irrelevant

– Markets discouraged except for discretionary consumer goods

– Labor allocated by State: university grads, for example, are assigned jobs

• Role of Money (What is “money”?)

– Unit of account but

– Not means of exchange

– Thus not a store of value

Banking under the Plan

• Since prices are artificial….

• …. profits (and losses) are also artificial.

• Banks thus merely conduits for subsidies when “plan” prices didn’t cover costs

• Paying bills really wasn’t necessary - as long as an enterprise met its quota

Problems of Formal Planning

• Incentives:– Labor mobility is discouraged

– Career is thus within the firm / bureaucratic

• Bureaucratic Games: budgeting– Ratchet effect: success doesn’t pay

– Micawber effect: but don’t fail, either!

The Economics of Scarcity

• Budget constraints are “soft” (Janos Kornai)

– Micawber effect again: hoard goods!– Firm structure also reflects

• Vertical integration• Exacerbated in China by local autonomy• Ditto due to local self-sufficiency ethos

• True of China also?– Much less articulated economic structure– Constraints on size of urban sector

Kornai: bureaucratic games pervasive

• Excess demand is thus pervasive– Hence “fixers” are needed to get goods

• In China, guanxi “connections”

– Inefficient firms are allocated comparatively more resources, not penalized!

• Planners know this– Use of “taut” budgets / hard-to-achieve targets– Tolerance of high inventory levels– Experience and competence make a big

difference (as in any business context!)

Input-Output Planning

• Planners gain technical knowledge, esp. within their sector / ministry

• Hence they can predict inputs needed to gain desired outputs

• But aggregation issues: an increase in steel targets shifts ore demand and railroad needs and hence steel demand

• Maintaining consistency - material balances - is a real challenge

Matrix Algebra

• The final equation lets one check for consistency

• But it also permits optimization– Convert to an inequality– This defines a convex set and the system thus

has a clear maximum– Linear programming permits solutions

• Optimization however has numeric limits– In the sophisticated USSR, only 1000 goods...

Formal Procedures

• Mathematical models help - used in Russia.– “Simplex” method and other linear algebra techniques

developed there.

• Each industry is a row in a matrix, with inputs needed per unit of output

• Matrix algebra then makes it easy to calculate needs and check consistency

Planning in Action

• Technical Change and Coordination– Vertical structure:

• Change requires getting Ministries to agree• Few rewards for improving a good

– Bias towards large projects– Easier to expand than to change

• Diminishing returns set in quickly– Plan relies on investment, not productivity– Bias toward heavy industry and tangible goods

over consumer goods and services

Planning is Inexact

• Fragility: Plans are never perfect• Annual cycle does not guarantee timely inputs• Mistakes are amplified / cascade to other firms• Hoarding is necessary• Hence “fixers” are necessary, even desirable!• What is “corruption”??

• Disaggregation• Even with supercomputers, only 10,000 goods

– China “planned” about 600 items– In agriculture, State determined what crop you planted:

grain first

• System must grant discretion to operating level

Planning is Political

• Bureaucrats decide goals, not consumers– Emphasis on what is tangible

• Guns and tanks are good

• Consumer goods are bad

• Services (especially merchants) are parasitic

– Emphasis on big over small - easier to manage

Planning games, continued

• Bureaucrats: power!– Nomenklatura: in China, little separation of

“party” and “government”– Infighting has huge social & economic impact

• Great Leap Forward & Cultural Revolution ...

• “Taut” plans can backfire– Ambitious targets counter political games– But infeasible targets generate chaos

• Hence an investment and inventory driven business cycle! -- instability just like in market systems?

Reforms

• “Big Bang” versus “Gradualism”– Partly political imperative in CSIS

• Political reform came first• No ability to wait or control economic reform

– Planning system collapsed with no coordinating institutions (markets!) to replace it

• In China, markets developed first– Reforms to economics institutions followed– Only now are political reforms underway

Genesis of Reforms

• Initial post-Mao policies focused on big-ticket projects, as in the USSR

• To speed up growth, use foreign technology

• How to finance? –– export oil!

• But oil prices fell…..and the fell further– End result: crisis

China versus USSR— Further Comparisons —

• In Russia, large state-run enterprises dominated the economy – Agriculture was less important– Planning was far-reaching & centralized

• In China, agriculture was central– Industry & urban areas were less important– Planning was decentralized – Planning applied only to key commodities

China: Reform Agriculture First!

• Grain prices were raised– Most of the population benefited immediately– Did not require elaborate administrative

measures!

• Large projects came on-line: fertilizer!– Serendipity…consumer goods output rose, too!

• Rural markets were allowed– Vegetables, meats but initially not grain– Benefited areas near cities the most

Responsibility systems

• Household responsibility system as model– Fiscal equivalent: local tax retention– Agricultural model from around 1982– Industry contracting as well: profit retention

• Impact hinged upon extent of discretion– Grain production (quotas) still emphasized– Industrial planning system still in effect– “Fixers” were natural entrepreneurs

Dual-track pricing

• In agriculture– Fixed quota of grain as de facto tax-in-kind-cum-rent

– Above-quota grain at higher price, now freely marketed

• In effect a fixed-rent cropping system– Farmers saw big gains from increasing output

– Once quota met, freedom to specialize in other crops

• Tenure not guaranteed until very recently– Some abuse of assets / lower level of investment

– Also decollectivization hurt mechanized wheat regions: these areas had (and lost) economies of scale

Dual-track pricing

• In industry, formal plans / quotas persisted• But above-quota output could be marketed

– Logic is similar to that of agriculture

– Ditto county / township / village tax system that is highlighted in the Oi book

• Allowed markets to gradually develop– In the meantime State-Owned Enterprises could obtain

“plan” mandated inputs and maintain prior output levels

– Enterprises with “free” inputs (small coal mines) were profitable, those needing purchased inputs suffered

– Also huge variations in efficiency across space

Persistent problems

• Dictates of State (plan) and People (markets) differed– Many SOEs have no or poor markets, e.g. the small

truck factories present in each Province

– Some goods no longer needed• we will see this in the Daqing “Working” video

• But “iron rice bowl” obligations persist– Under Mao’s decentralized polity, SOEs were direct

providers of social services, not the State

– How finance deficits? - borrow from banks

China’s looming financial crisis

• Historically banks in China weren’t “banks”– SOE’s functioned according to plan

– Loans were an accounting convenience

• SOE’s relied on loans as market expanded

• But now banks are technically insolvent– Social security system must henceforth be run by gov’t,

not by SOEs

– Gov’t must nationalize the cumulative “loans” that represent past social security obligations

– Banks then can start afresh, as real banks

Demographic changes, too

• Social security needs aren’t funded

• But the population is aging rapidly– The “baby boom” peaked 1965-70

– Labor force growth is already slowing

• Capital markets are now crucial– Planning is dead!

– Diminishing returns: more capital is needed to get the

same increase in output

– Private savings will replace / supplement SOE pensions

China: Opportunities Remain

• Urbanization and household formation– Stimulates demand

• Construction is labor-intensive

• New households require new consumer durables

– Cities pollute less than the countryside– Urban infrastructure enjoys economies of scale

• Education levels still rising– full effect only when today’s youth hit middle age

• Behind technically: productivity will rise!

The End