It is known that market failure is a common phenomenon in economic development. Therefore, the third plenum proposes to optimise the role of the government and ensure effective regulation to “remedy market failure”.

Where does market failure occur? It may be different across industries and stages of development. Thus, if the government wants to play a better role, it must be flexible and take measures according to the situation.

So this is not a downgrade of the role of the market, but a further explanation and improvement of the role of government, of which the ultimate purpose is to let the market play a decisive role in resource allocation.

The third plenum decision also said the government should “lift restrictions”, but when there is market failure, or when a monopoly occurs, it must “strive to better maintain order”.

From the perspective of new structural economics, an effective government is the condition for an efficient market, and an efficient market is the goal for an effective government.

Why is an effective government the condition for an efficient market? Because if the government does not manage or intervene when there are market failures and monopolies, the market won’t be efficient.

And what is the purpose of the government’s actions? It is to make the market more efficient, so an efficient market is the goal for effective governance. Market failures will not disappear if the government does nothing. But if what the government does exceeds what an efficient market needs, it may hinder the market from playing a decisive role in resource allocation. So this is a balancing act.

To sum up, a decision on improving the market has been made in response to the new situations facing China’s current stage of economic development. Government policies must be flexible: restrictions should be further lifted accordingly to help enterprises seize development opportunities. But when monopolies and systematic risks occur, the government should be able to maintain order.

03:14

China’s Communist Party wraps up policy meeting amid growing uncertainties

China’s Communist Party wraps up policy meeting amid growing uncertainties

Economic development requires continuous technological innovation and industrial upgrading, which in turn require research and development. In the process of innovation, there will inevitably be many market failures. As the product of research is a public good that does not yield high profits, enterprises may not be willing to invest if the government does not support them. And if the government does not provide patent protection to new inventions, firms will not be willing to develop new technologies either, as it can be easy for others to copy.

For developing countries, we must continue to climb up the industrial ladder, from industries with low productivity to those with high productivity. Of course, if you want to succeed in the process, there is a very basic principle: it must be based on comparative advantage.

If you violate the comparative advantage principle, you may fail as a pioneer and bear all the costs. But the failure can warn latecomers against jumping in.

When the pioneers succeed, everyone will know that this new industry is in line with our comparative advantage and will then follow, which leads to competition. In this stage, the pioneers can only earn average profits, which are the same level as those of the latecomers.

So regardless of success or failure, the industrial pioneers will create useful information for society. However, the cost and benefit are asymmetric. If the government does not provide compensation for the information externality created by first movers, no one will be willing to become one, and the industry will no longer be upgraded.

The new industry may also need a lot of things that entrepreneurs cannot or are reluctant to provide, such as workers capable of using the new technology, because the firms may find the workers they have invested huge amounts of money in to train can be easily attracted away by latecomers and competitors with slightly higher wages. Other examples include infrastructure, financial and legal institutions.

But the resources that the government can leverage are limited, so it should allocate limited resources to those industries with comparative advantages. Such action is industrial policy.

Even though industrial policy has been deemed as wrong for a long time, we have not seen any developed country that can maintain its leading position in the world without industrial policy. If the government does not support basic research, technological innovations will stagnate. This is essentially industrial policy, even though they do not acknowledge it.

The basic research for various technologies and industries the United States is leading the world in were all supported by the US government in the early stage. Mariana Mazzucato, an Italian economist, called the US government an “entrepreneurial state”.

But unfortunately, developing countries have been told they cannot use industrial policies for anything more than supporting basic research. Most have been brainwashed.

Since World War II, there are few developing economies that have been able to catch up with developed countries, as most have fallen into the poverty trap or middle-income trap – except for a few East Asian economies and Israel, which have used active industrial policies to support the development of their comparative advantages.

I support industrial policy not because I like it. I follow the principle that to develop, any economy must let the market play its role, give entrepreneurs enough incentive and leverage the government to overcome market failures entrepreneurs cannot solve on their own. Industrial policy is one of the tools, and I’m happy to see that this has become a consensus recently.

Intellectuals in developing countries have the responsibility to summarise our own experiences and propose new theories. We should not simply wait for developed countries to tell us what we can or cannot do. We should do whatever we think is effective.

Of course, most industrial policies eventually fail. Under such circumstances, I think what scholars should not do is say that because there are failures, we oppose industrial policy. Just like we can’t say we don’t need entrepreneurs because most start-ups eventually fail.

Instead, we should study what kind of industrial policies succeed, so when we formulate more in the future we can ensure a higher probability of success and a lower probability of failure.

In the 1980s, Japan’s gross domestic product reached 65 to 70 per cent of the US’. And China’s economy is now between 60 and 70 per cent the size of the US’, so it seems to be the same situation.

The US attitude towards Japan at that time was a bit like its current attitude towards China – you can’t surpass me. If you try to surpass me, I will use various excuses to suppress you. In the 1980s, many of the world’s leading semiconductor companies were in Japan, and Japanese cars were better, cheaper and of higher quality than American cars.

And then the Plaza Accords were signed in 1985. This forced Japan to raise the yen’s exchange rate from 260 yen per US dollar to 120 yen per US dollar, making Japanese exports less competitive.

Regarding Japanese auto exports, the US government used overcapacity as an excuse, and then limited the number of cars that could be exported to the United States each year. At the same time, Japanese car companies were required to invest in the US for production.

The US also said that chips made in Japan would threaten its national security, so the Japanese had to transfer technology through joint ventures with American companies, and production could not be concentrated in Japan. So they were dispersed to Samsung, TSMC, or back to the United States.

As a result, Japan experienced a 30-year economic depression. In the 1980s, Japan’s per-capita GDP was actually about 130 per cent of the United States’ per-capita GDP. Now it is less than half, and Japan’s total GDP is less than 20 per cent of the US total.

I don’t think China will follow Japan’s path.

China still has many latecomer advantages in upgrading its industries. Its current per-capita GDP is only about a quarter of the US’ figure, if calculated based on purchasing power parity. If calculated with market exchange rates, it is about one-sixth.

In addition, because of the fourth industrial revolution, China is competing with developed countries in new industries such as AI and big data from the same starting line.

At the same time, China has four advantages in these new industries. First, these new technologies require skilled workers, and China has a lot.

Second, China has a large domestic market where new inventions can immediately enter. Where economies of scale are achieved, production costs are low, strengthening global competitiveness.

Third, if these new inventions require hardware, China has the best manufacturing ecosystem.

Fourth, China combines the role of an efficient market with that of an effective government. We have industrial policy in China.

Why did Japan lag behind? The term industrial policy was coined by the Japanese. It was after World War II that Japan’s Ministry of Industry and Trade began to use the phrase to refer to efforts made by the government to support the development of new industries.

But after the Plaza Accords, the US said industrial policy was wrong, as there were many failures, so countries should not use it any more. Japan listened.

Think about it. After the 1980s, which world-leading industries were invented by Japan? Japan’s economic development stagnated because it gave up industrial policy to incubate new industries. But China will not do that, so China will continue to develop.

At that time everyone thought that Japan’s economy would surpass the US, but it was eventually misled. And China will not be misled.

“Private enterprises lack confidence,” everyone says. But now the best-performing enterprises in China are private firms, in industries like EVs, solar panels, and lithium batteries. Do they not have confidence? If not, how can they develop so well and have such great competitiveness in domestic and international markets?

So when we say that private enterprises have no confidence, it may depend on the sector. They may be in traditional industries. They may rely on exports. These companies are not willing to invest now, but what is the reason behind this?

The international market has not yet recovered. Before 2008, the world economic growth rate was about 4.5 per cent annually, and the growth rate of global trade more than double that figure. After 2008, the world’s economic growth rate declined to a little over 3 per cent, down one-third, and the trade growth rate was less than the economic growth rate.

China, as the world’s largest exporter, was the most affected by this. More than 95 per cent of China’s export sectors come from private enterprises. When the country’s annual export growth dropped from more than 15 per cent to only about 5 per cent, a lot of excess capacity had to emerge.

So it is true that many private firms have no confidence in investment, because they are affected by these external factors.

Many attribute the lack of confidence of private enterprises to the expansion of the state sector. It is true that the proportion of state-owned enterprises (SOEs) in the overall economy has been rising since 2008. But was the increase a result of squeezing out private firms? Or was it because the private sector was not performing, and SOEs had no choice but to shoulder some countercyclical intervention to stabilise economic growth and employment?

In recent years, all the major public infrastructure projects such as highways, high-speed railways and 5G communications were done by SOEs. These SOEs increased investment, so their proportion in the economy went up.

But has this squeezed out or actually helped private enterprises? In fact, it was more of the latter. Because when SOEs make investments, they create jobs, leading to an increase in residents’ income and thus consumption. And consumer products are all produced by private firms.

When SOEs invest in big infrastructure projects, the steel, cement and equipment are also mostly produced by private companies, thus these investments create new markets for them.

China’s SOEs are concentrated in sectors related to defence infrastructure, or natural monopolies such as power and telecommunications. These are essential for maintaining economic security and development, so of course they must be made “bigger and stronger”.

And if they become bigger and stronger, it can reduce the transaction costs of private firms. For example, China’s infrastructure is the best among developing countries, and that is why companies like Meituan, Pinduoduo and JD.com can grow so fast in China.

So when we talk about making SOEs bigger and stronger, we need to look at which industries. They are not competing with private firms, but strengthening themselves in sectors to serve private businesses or safeguard national security, which is ultimately conducive to the development of the private sector.

China is a large economy, and internal circulation is a key advantage. If the national market is fragmented rather than unified, there will be no such advantage. Reform and opening up is a gradual, dual-track process. At the beginning, the government retained many interventions in the economy.

It continued to subsidise several capital-intensive heavy industries, violating comparative advantage to maintain stability. It also liberalised investment for private and foreign firms in some labour-intensive processing industries in line with comparative advantage, actively helping them address market failures such as poor infrastructure by building industrial estates where the business environment could be improved immediately. These labour-intensive sectors were thus able to develop rapidly. This is a major reason why China could maintain stability and achieve rapid development at the same time.

However, because of the interventions, market operation was not smooth. To subsidise capital-intensive industries, the government intervened in factor prices, including the prices of mineral resources and interest rates.

But China’s gradual dual-track reform was very efficient. Industries with comparative advantages have developed rapidly, accumulating massive capital, and the old capital-intensive industries have gradually come in line with comparative advantage, no longer needing protections or subsidies. This was why the third plenum in 2013 proposed to let the market play a decisive role in resource allocation, because we no longer needed the government to artificially intervene in prices.

This is just one of the conditions for a unified national market. The formation of a unified national market also depends on the quality of infrastructure. If your infrastructure is not good, you will only have regional markets, not a national market.

Of course, China’s infrastructure has been getting better in recent years. So whether it is market price liberalisation or infrastructure, the conditions for a unified national market have gradually improved, but new situations have also emerged.

For example, data has become a new element. To make sure data can flow according to market demand, we must clarify who owns the data and can use the data. There must be regulations.

So to establish a unified national market, China must continuously improve the policy environment according to the new situation.

First of all, fiscal and tax reform. Now, everyone is very concerned about local government debts. Why do local governments have those debts? Because our local governments were not allowed to have a deficit on their budget.

After the international financial crisis in 2008, China undertook a lot of infrastructure projects to stabilise employment and economic growth. Within that 4 trillion yuan (US$551 billion) stimulus package, the central government only provided 1.2 trillion yuan, and the remaining 2.8 trillion yuan had to come from local governments.

But as they could not have a deficit, they set up local investment platforms and borrowed money from banks to build these projects. As the money was underwritten with local government credit, it inevitably became hidden debt. Even if they are not shown in the budget, the liability belongs to the local governments.

One problem here is that these infrastructure projects are long-term projects, but the money they borrowed is short-term debt, so there is a mismatch.

So, how to solve this problem? First, the local government debt problem in China is not as bad as it looks. One big difference between local government debt in China and in other countries is that foreign debt is real debt, because most of the money borrowed is used to boost consumption or relieve unemployment. Most of the debt of Chinese local governments, however, was used for infrastructure investment, which means there are assets underlying the debts, so the net debt is much smaller than nominal.

Second, many developing countries borrow money in foreign currencies, and China’s local government debts are yuan-denominated. Usually debts in a country’s own currency are not likely to lead to a crisis, as the country can print more money.

So we don’t have to worry too much about China’s debt problem, but it does not mean there is no need to solve it. And the solution is just like what the documents of the third plenum say – that is, let local governments’ fiscal revenues match their responsibilities.

And if the central government should issue a policy that needs infrastructure, the money should come from the central government’s pocket.

I think the third plenum shows China’s fiscal reform is heading in the right direction. More specific details will follow, maybe at the Politburo meeting, the annual central economic work conference or the 15th Five-Year Plan.

Another noteworthy reform task is the hukou, or household registration system. The process of economic development is accompanied by urbanisation, where rural populations enter cities.

But with our old hukou system, when rural people moved to the cities, they could work or buy property but they could not enjoy the same public services – healthcare, education for children – as urban residents. And now such restrictions are gone.

So this is also a very important institutional reform, which is another key element to the establishment of a national unified market as we mentioned earlier.

China’s national unified market is already quite perfect in terms of the flow of products and commodities. The main obstacle is the factor market, including the labour market. So hukou reform is key to further deepening the market economic system.

Troops for the enemy, earth for floods: there will always be a way out. China should continue leveraging its advantages to develop its own economy well, open up its economy and let China’s development become something other countries can rely on.

The US’s economic containment of China will certainly create difficulties for China, but it also creates difficulties for itself.

Why is inflation so high in the US? Because it is cheaper to import directly from China. Now instead of China, it imports at higher cost from Mexico and Southeast Asia, even though many intermediate goods still come from China. So even if China’s exports to the US have decreased, our shipments to Mexico, Vietnam, Cambodia, Indonesia and Malaysia have increased. So the overall impact [of US tariffs] on the US is greater than their impact on China.