China’s New Model of Economic Growth Joseph E. Stiglitz March 2007

Why a New Model? At each stage of its development China has adapted its economic model to the new circumstances China has had enormous success over the past 30 years. As old problems have been solved, new problems are presented. A new economic model is needed to solve these problems. China’s economic circumstances are markedly different from those of other countries, so it cannot simply borrow models that have worked elsewhere.

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

While model has changed, objectives remain the same 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

Will move away from export led growth led to a slowdown of growth? No—if appropriate policies are put into place Exports played a critical role in earlier stages of development –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 domestic demand (capacities to allocate resources domestically)

Today, China is at a new stage… Exports will continue to be important, but the various roles that exports played can be achieved in other ways –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 –Strengthened financial institutions can do a better job at assessing creditworthiness Warning: exploitive financial institutions, combined with bad bankruptcy laws, undermining social harmony

Promoting Consumption But primary reason for excessive savings is not lack of access to finance “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

Western Technological Developments May Not be Consistent with China’s Social Goals Pays to much attention to reducing demand for labor Pays too little attention to reducing the demands on the environment

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 Critical for China –China is entering phase in its development where it is imposing huge demands on environment –Old model simply isn’t sustainable 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

Innovation is endogenous –Both level and direction –Policies can affect both level and direction –Can have “equality-enhancing” (or even job-inducing) innovations and resource saving 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

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 Which is why there needs to be a broad based program to encourage the right amount and level of innovation –Especially as China moves away from its old economic model, which was based on importing technology and exporting goods

Portfolio of instruments in achieving an effective innovation system directed at social needs Key role of government research Prizes for innovations that meet important social needs Balanced intellectual property regime –High cost of IPR regime in terms of inefficiency Knowledge is a public good Restricting use is inefficient Giving monopoly power creates an even greater distortion Justified only if it stimulates innovation sufficiently –Little social benefit from IPR on traditional knowledge (bio-piracy) –Unbalanced regime can retard innovation Knowledge is the most important input into research Patent thicket (conflicting patents) can impede innovation Monopolies have insufficient incentive for innovation, and can discourage innovation from potential competitors

“Balance” determined by a host of factors Length of patent, what can be patented (genes, mathematical theorems, business practices…), standards of novelty, procedures for granting and challenging, enforcement 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 –Increased questioning of system And is even more poorly suited for China

There is more than one IPR system even within the obligations of WTO –E.g. in challenging patents –With Europe more sensitive to the bias towards patenting rather than keeping ideas in the public domain (it is a public good to challenge a patent) The use of a liability system for enforcement –Even U.S. Supreme Court seems beginning to realize problems with current system Use of compulsory licenses, especially for health needs –Among hard fought for “flexibilities” in Uruguay Round –Essential for achieving health goals –China could make large contribution to well-being of developing countries by developing strong generics industry

Institutional Foundations for Market Economy Key to success of 11 th five year plan and implementing New Economic Model There are many different forms of a market economy –Some versions of “unfettered markets” more extreme than that implemented in any market economy

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 Details matter –And there are often unintended consequences of well-intentioned policies

Example 1: Property Rights Principles illustrated by discussion of property rights system (including intellectual property rights) –Even formulation needs to be changed –Responsibilities as well as rights Owners of land are responsible for making sure that land is not used as a toxic waste dump, polluting ground water Firms have responsibility to treat workers properly –Example of “relationship” nature of rights/responsibilities –Worker rights/firm responsibilities –Key role of restrictions Owners of IPR cannot engage in anti-competitive behavior Government has right to issue compulsory licenses –These are social constructions that need to be adapted to the circumstances, history, and objectives of each country

Property rights/responsibilities agenda has to be balanced with other rights/responsibilities, e.g. workers rights/responsibilities, consumer rights/responsibilities, borrower rights/responsibilities Essential for creating a harmonious society

Unintended consequences of unbalanced rights agenda Creation of landless farmers –Especially if there is inadequate public social insurance system (health system) or inadequate protection against abusive lending practices Individuals borrow to obtain medical services for parent In other countries, major cause of social distress –Besides social consequences, impairs overall efficiency of economy Increased agency problems

2. Social Welfare China provides insufficient support for wide range of basic needs –Retirement, health, education –Support has not kept up with progress in other areas –Partly accounts for growing inequality, poor performance in health statistics –Government announcement of commitment of more funds important step

Social Welfare Stronger social welfare will also help China in its move away from export dependent growth –High savings motivated by weakness of public social safety net And would contribute to continuing growth in productivity –High returns to investments in education and health Needs to be innovation in delivery mechanisms –Reliance on private markets for health has failed in most countries U.S. spends more, poor outcomes Especially inconsistent with goals of social harmony

Social Welfare Strong social safety net can enhance competitivity –Enhancing ability and willingness to undertake risk Need to create national marketplace –National social insurance program –Separate production from provision of social services

3. Tax Policy Key role in allocating resources China’s problems different from other countries, needs to be taken into account in designing policies –China is trying to encourage consumption –Other countries trying to encourage savings –Argument against consumption based V.A.T. for China China’s problems today different from earlier –Differentiation between foreign and domestic firms no longer justified Dangers of tax competition Should be level playing field between domestic and foreign entrepreneurs –Perhaps tilted towards domestic—presence of externalities

Tax Policy Key problem today is environment –Desirability of introducing environmental taxes Like carbon tax –Raising revenues at the same time as improving efficiency, sustainability of growth Improving energy efficiency Reducing carbon emissions Imposition of export tax would simultaneously reduce trade surplus and provide additional revenues Government needs more revenue to achieve social objectives –Could increase tax/GDP ratio without significant adverse effects on growth with well designed tax policies

4. Financial Sector General consensus of important role for government –Widespread market failures Example of general theoretical results concerning efficiency of markets with imperfect information Financial markets are concerned with gathering, processing, and using information –Roles in (a) ensuring safety and soundness; (b) consumer protection; (c) maintaining competition; and (d) ensuring access to credit for underserved groups/sectors

Financial Sector Access especially important for achieving objectives of New Economic Model –Even in advanced industrial countries, government has played an important role in ensuring access to underserved groups (through CRA requirements), to small businesses (through SBA loans), to students, for housing, and to the rural sector

Financial Sector Capital and financial market liberalization may not lead to more growth, but may lead to more instability –Reduced supply of loans to small and medium sized businesses –Pro-cyclical capital flows Implication: caution in liberalization; policy of gradualism

5. 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 cannot solve immense coordination problems There may even be perverse incentives on the part of markets and some government officials –Has to be carefully designed to avoid abuses

6. 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 11th five year plan reflected this New Economic Model –I have tried to lay out some of the economic foundations underlying this New Economic Model