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 11 th 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 11 th five year plan reflected this New Economic Model –I have tried to lay out some of the economic foundations underlying this New Economic Model