The Social Science Journal 48 (2011) 1–12

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The Social Science Journal

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The 2010 Western Social Science Association Presidential Address

The role of the state in structural transition and economic crisis

Jack W. Houa,b

a Dept. of Economics, California State University, Long Beach, USAb School of Economics, Henan University, China

a r t i c l e i n f o

Article history:Available online 18 February 2011

a b s t r a c t

As academicians, we emphasize to our students to keep up with class, and always readahead. When I took over as President-elect of the WSSA in April of 2008, while busy com-municating with the Section Coordinators and plan the 2009 Annual Conference (Reno,Nevada), I would occasionally pause and ponder what I would present for my PresidentAddress (reading ahead). What do I know that would be of interest to the general mem-bership of the WSSA? I naturally thought of China and its economic reform, as half of myresearch output over the last decade has been in this area. Then, the subprime crisis came to

be, and I wondered about how the economy would cope. I can claim some expertise to theformer, but of no special authority regarding the latter. However, I do have some thoughtsregarding the role of the State during such economic upheavals, but in a more conceptual

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or a black cat. It’s a good cat as long as it catches mice.”This was interpreted to mean that being productive in lifeis more important than whether one follows a communistor capitalist ideology.3 China formally put forth the direc-

1 If the South were to seek independence, the Federal government’sresponse is predictable, as the Civil War is the hidden wound of the U.S.

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. Introduction

As a newly minted PhD in 1989, I watched with intensityhe development of the student demonstration at Tianan-

en Square (Square of Heavenly Peace). I felt China was onhe threshold of a major political breakthrough and wantedo head for China to be part of the movement. Clearer mindsround me persuaded me not to follow through. The reac-ion of the Chinese government was unfortunate to say theeast, but I often remind students that like us, each nationas its own hidden wounds that can easily be triggered intohat could be considered as an irrational reaction.

In their civil war with Chiang Kai-shek and the Chi-ese Nationalist Party (KMT), the Chinese Communist PartyCCP) used numerous innovative “guerrilla” warfare tac-ics, of which student demonstrations was an integral partf their arsenal. What were the students demonstrating

gainst? It was the corruption, crime, inflation, and otherocial ills. Fast forward to 1989, what were the Tianan-en students demonstrating against? Corruption, crime,

nd inflation. Knowing how powerful student demonstra-

E-mail address: jackhou@csulb.edu

362-3319/$ – see front matter © 2011 Western Social Science Association. Publioi:10.1016/j.soscij.2011.01.001

tion.cience Association. Published by Elsevier Inc. All rights reserved.

tions can be (after all, it was a major instrument in topplingChiang Kai-shek only a few years after emerging as the warhero of WWII), the CCP’s hard line response at Tiananmenmay not be irrational to the Party leaders.1

As tragic as the event was, it also pulled China backfrom 10 years of Comprehensive Reform (CER).2 This polit-ical retreat and economic stagnation continues for severalyears till the famous Southern Tour where Deng Xiaopingmade the famous statement, “I don’t care if it’s a white cat

One can imagine the criticism from Gorbachev as an over-reaction, afterall Lithuania, Estonia, etc., won independence one-by-one without majorcivil war.

2 For a discussion of the reforms leading up to Tiananmen, refer to Feiand Hou (1994).

3 A bit of history. Deng actually uttered this most famous quote muchearlier at the 1961 Guangzhou Conference, which marked the splitbetween Mao (CCP Party Chairman) and Liu Shaoqi (the GovernmentChairman, equivalent of President), as the latter openly criticized Mao

shed by Elsevier Inc. All rights reserved.

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2 J.W. Hou / The Social S

tion of constructing a “socialistic market economy withChinese characteristics” and has not looked back since. Atthe start of the CER, China declared the national objectivewas to quadruple the 1980 real GDP by the next millen-nium; China achieved that in 1995.4 The economic growthhas further accelerated after 1995, as China rolled out manymore progressive economic reforms, attracting astronom-ical levels of foreign investment, making China the Factoryof the World. As a final measurement of China’s economicsuccess before we move on to the theme of this address,the per capita GDP in China was 381 Yuan in 1978 at thestart of the CER, by 2007 (the year before the U.S. subprimecrisis that was felt worldwide) it was 18,934, a 10.9 timesincrease in 30 years.

In comparison, Russia exhibited a dramatically differentpost-socialism experience. If we use 1989 as the startingpoint (of comparison), by 1999 China’s GDP has nearly dou-bled, while the Russian GDP shrunk more than 40% (Stiglitz,1999). By 2007, they had finally regained their pre-reformGDP, but the ensuing subprime crisis had a far more nega-tive impact on Russia than on China (China’s GDP still grewat 8.7% in 2009). Comparing and contrasting the experienceof these two dominating former socialist economies is bothinevitable and necessary. Both are waging a great battle forthe survival and prosperity of its people. “Great battles,”Winston Churchill remarked, “change the entire courseof events, create new standards of values, new moods, inarmies and in nations.”

No two battles are the same; the same can be saidregarding the reform attempts by the various former social-ist nations. Their approaches, paths, and effectiveness differdue to many reasons, trying to develop a single model willbe missing the main point, whereas history and evolutionof events provide complex texture to the understanding ofthe transition process. The importance of history on for-mulating economic models (Arrow, 1986; Solow, 1986) orpolicies is never more evident than the question we areaddressing here.

Over the years, I have been asked many times whetherthe Russians would have been able to succeed if they mim-icked China’s reform sequence/strategy. More precisely,if the Russian leaders had been more patient and imple-mented a reform that was more gradual like that of China,would their economic performance be better? This is muchlike asking the question, if Socrates had died at the Bat-

tle of Delium (424 b.c.) during the Peloponnesian War(431–404 b.c.), what would the Western civilization hadevolved into (Hanson, 2003)? Or, in a more Chinese con-text, if Confucious died at Gaixia,5 what form would the

over the failure of the Great Leap Forward. In 1963, as Liu’s top lieutenant,Deng implemented economic policies that were prototypes of the currentCER (Fei & Hou, 1994).

4 This is despite the severe contractionary policy in 1994 to combatChina’s worst inflation since 1989 (which was a major cause of the Tianan-men student protest). Refer to Chang and Hou (1997) for more details ofthis pivotal year.

5 Confucius was touring the many State of the time looking for a rulerwilling to allow him to implement his ideals to construct the model State.At Gaixia, the local peasants mistook Confucius for an infamous gangster.And cornered Confucius and his entourage of students with the intentionof starving them to death.

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Chinese culture have become? It is a meaningless, butnevertheless, intriguing question; and it will be where Istart.

2. Is the invisible hand too “invisible”?

Most of us who went through neo-classical economictraining in the West are lured into two misconceptions.One is that the “market” always exists, and the second isthat adjustments are instantaneous. The latter is the directresult of mathematics and living in the ivory tower. Oneonly needs to take a look at the real world and understandthat any changes will take anywhere from months to a gen-eration before it is fully imbedded into the system. Let usbe generous for the time being. If the real world is indeedas characterized by neo-classical theory, then the Rus-sian big-bang (the immediately withdrawal of governmentintervention) approach should have allowed the full capac-ity of the invisible hand causing the non-performing ornon-viable firms to be eliminated by competition, leadingto an efficient and viable economic system. In contrast, thegradualism approach of China should have led to inefficientstagnation. This prognosis, of course, is utterly shattered bythe actual performance of these two economies.

As Lin (2005) correctly pointed out, the rigorous tran-sition policies advocated by the World Bank,6 the IMF,and noted economists at Harvard and MIT, failed becausethey emphasized the economic viability aspect. They con-centrated on such issues as property rights, corporategovernance, government intervention, and others relatedto the firm’s management. However, Lin argued, these arecentral to the viability of firms, but the existence of manyfirms in the transition economy was not based on com-parative advantage but on other political or non-economicprinciples (in other words, they did not evolve in the Dar-winian sense). Unless the policies address these real issues,they are bound to fail.

I certainly agree with Lin’s assessment. The fact thatboth Russia and China over-emphasized the develop-ment of “secondary” (heavy) industries, at the expenseof primary (agriculture) and tertiary (light or consumer)industries, clearly demonstrates the guidance of the Staterather than via traditional comparative advantage. Thisis not just prevalent in centrally planned economies, butalso in the case of many contemporary LDCs. As theState has invested heavily in these “favored” sectors,the amount of fixed capital and employment are usu-ally very high. If one induces shock therapy and forcethe non-viable firms into bankruptcy, the waste of thefixed investment will be considerable, but more trau-matic is the massive unemployment this would potentiallyimply.

Thus, unless the invisible hand works almost instanta-neously, this reallocation of resources will most assuredlygenerate panic and chaos. To further compound theissue, what if the market mechanisms that the invis-

6 Lin is currently Vice President and Chief Economist of the World Bank.Perhaps his insight will aid in how the World Bank deals with similarissues in the future.

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ble hand relies on to efficiently reallocate resourcess imperfect or even absent? Then we will have theestruction of the old (though admittedly inefficiententrally planned resource allocation) with no other sys-ematic and system-wide mechanism to take its place.

hat would we expect to ensue? The crisis of the Rus-ian economy in the 1990s demonstrated this painfullylear.7

To summarize, nature does not look fondly at mutations,ut rather favors gradual evolutions. The market systemhat the capitalistic West has been so accustomed to is thend result of two hundred plus years of continued evolu-ion. In contrast, the central planning Soviet style can benterpreted as a mutation politically created by Lenin, whilehe big bang approach adopted by the Russians 70 plusears later paramount to a repeat of the mutation process.he gradualism approach that the Chinese chose allowsor the market to develop and catch up with the changingconomic mechanism.

Whether this is by luck or by design (though I willake some conjectures in the next section) is really not

mportant. The success of China and the painful experi-nce of Russian and Eastern Europe clearly testify to theact that if the market mechanism is imperfect or lacking,nd if adjustment is not instantaneous, the shock therapyr “big bang” will only deliver a painful lesson with lesshan substantial results. Though the government leadersre to blame, so are we the Western trained economists,s we have fallen into the trap of believing the invisibleand exists universally and that adjustments are almost

nstantaneous.

. Gradualism by design?

As mentioned earlier, nature favors an evolutionarypproach rather than sudden mutations. If we categorizeussia’s shock therapy as a mutation, then the gradualismf China should be classified as an evolution path. The nextuestion to ask is whether it was a deliberate design byhe Chinese leaders or a pleasant accident? And whetherhis can be attributed as the cause of China’s success andussia’s failure?

For the first question, the opinion in the literature seemso suggest it was not a design. Perkins (1988) stated,

“It is unlikely that China’s leaders had worked out ablueprint . . . This reform process was still under wayin 1987 and appears likely to continue for some time.Where it will all end is not known to anyone eitherinside or outside of China.”

True as this may be at the time when Perkins wroteis milestone paper,8 the epoch ending events of the lastecade of the 20th century (Tiananmen, fall of the Berlinall, liberalization of Eastern Europe, and the disintegra-

7 Most of the Republics of the former USSR are suffering the same hard-hip. A recent book by Craig MacPhee (2005) has a detailed and in-depthook at the chronicles of the Georgia Republic.

8 Documentary evidence shows that the Chinese reformers clearly had“capitalistic” blueprint in mind, at the latest, in 1984. This is evident in

he Central Committee (1984) document.

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tion of the Soviet Union) should leave no doubt in anyone’smind as to where the reform will end.9

Though the question of whether China has a specific“plan” for its continued reform may still be debatable, twofacts are clear. First, the direction of the reform is clearlydetermined, and China has most assuredly passed the pointof no return. Second, such a direction and determinationwas most likely absent in the early stages of the reform. AsChow (2002) pointed out, the Chinese leaders were prag-matic and not subject to ideological restraints. There wasno blueprint for the economic institutions to model afterand policies were adopted through experimentation andlearning-by-doing (or in Deng words, “crossing the riverwhile feeling the rocks.”). This pragmatic attitude followedthe mode of experimenting at a smaller scale, if it is provento work, then adopt at a larger scale.

The responsibility system was the result of a series ofexperiments locally, and then adopted nationally because ithad worked well. The 1984/1985 reforms of the SOEs (StateOwned Enterprises) began with allowing partial autonomyto a select group. With the success and the experiencegained, it was extended to more SOEs and with a greaterdegree of autonomy as the experiment continued (to thisday). The experiments with the SEZs (Special EconomicZones), stock markets, and the policy towards FDI, all fol-lowed the same pattern. This is very much the same styleas what sculptors and architects do, they start with a small-scale model before committing to a full size production. Inaddition to this analogy, the experimental approach has itsnecessity in China’s case.

The small-scale experiments verify what works andwhat does not without causing too much disturbance tothe establishment. Such experiments take time, and allowthe reform-oriented Party fraction time to reconcile theideology of this experiment with socialism doctrine. Oncethe experiment proves viable, the reformists can then con-vince the broader based Party to adopt and implement alarger scale program. This is a patient and cautious attitude,which is typical of Chinese. In contrast, the “shock ther-apy” adopted by Russia and Eastern Europe demonstratestheir desire to change to a market economy immediately(hence suffering from the structural problems discussed inthe previous section). This too is natural from their histor-ical heritage: small nations (Eastern Europe) or a large butfeudalistic country (Russia).

The piece-meal experimental approach adopted byChina is by definition slower going, and is imbedded intothe Chinese cultural over the past two millenniums. Chinahas been a large unified country for more than 2,000years.10 Though an all-powerful emperor that is the “son of

heaven” rules it, the actual governance is done by a vast andcomplicated bureaucratic system that rules the nation withenvisage of the emperor’s will. These “envisage” and theoperational governance of such a large country by such a

9 Indeed, some may be as so bold to predict the inevitability of themarch towards a capitalistic market system, even if it is with Chinesecharacteristics and socialism bent (Hou & Hou, 2002).

10 This is another reason why “patience” is a cultural trait. When time ismeasured in centuries rather than decades or mere years, patience seemsto be as natural as the air we breathe.

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underwent major changes. Mexico became more alignedwith the U.S., the Chilean Marxian government of Allendefell to the rabidly anti-Soviet regime of General Pinochet,and Argentina’s government was taken over by the anti-

11 The statistics is even more lopsided than it appears. These 19 facilitiesrepresented 85% ($392 million out of $461 million) of the total contract,with the bulk coming from Kellogg Continental of the U.S. and its sub-sidiary in the Netherlands. It is also worth mentioning that the natureof these early technology imports are not the same as the Foreign DirectInvestment (FDI) currently flowing into China, as they were “purchases”

4 J.W. Hou / The Social S

large number of bureaucrats necessitates coordination andforming a consensus. Is this not a “Chinese characteristic”?

In conclusion, this gradual approach of China can beviewed as by design due to the bureaucratic nature ofChina’s past; but it can also be viewed as a sign of a lackof consensus regarding what and how to do things. Thetwo may be observational equivalent, and probably bothtrue. But, just like putting together a thousand-piece puz-zle, even if there were no idea (blueprint) of what to donext at the outset, after a certain point the big picture doesemerge and an implicit agenda must be there. Most believethat such a picture of China’s future has emerged, and thereis no turning back. This does not mean that we are nearingcompletion. On the contrary, the road is harder and longerahead, as the tougher reforms have yet to be done, includ-ing the reform on the financial sector, and political reformthat is needed to accommodate for all the market reformthat has been accomplished.

Following the pattern of previous sectors, we are nowready to lead into the next section. We can take two routes:the liberalization/democratic reform or look at the origin ofChina’s reform and why gradualism was the trait. I chooseto address the latter first.

4. Reform sequence

Whether the cautious or piece-meal method is due tocultural traits and/or lack of consensus within the Party, thefact is that the Chinese leadership did not have a blueprintin mind, at least at the outset. Despite this, it is also obvi-ous that the two nations took very different paths in termsof the sequence of their reforms. Russia concentrated onreforming the industrial sector, while seemingly aban-doning the agricultural side. In contrast, China’s reformcentered on the rural/agricultural sector exclusively for thefirst six years, if not longer. This sequential decision ofagriculture-first is consistent with the “dual development”theory of Fei and Ranis fame.

The literature has mainly attributed this to the differ-ence in the “initial conditions” between the two countries(Liu, 2001; Sachs & Woo, 1997). The most astoundingstatistics was the distribution of labor force between agri-cultural and non-agricultural sectors at the beginning oftheir respective reforms. For the former Soviet Union, 85%of the labor force was working in the non-agricultural sec-tor, while at the start of China’s reform only 18% of laborwere working for the non-agricultural sector. They arguedthat the fact that China was less industrialized there weremore space for them to mimic the Western experience.And, since agricultural population was so high, this releasedproductivity is also much larger than that of Russia.

This is a well established and accepted theory, and per-ceived as “naturally” the reason why the initial reform wasin the non-agricultural sector for Russia, while China beganwith agriculture. The literature has not really addressedthe more in depth cause of why the Chinese focused on

agriculture, besides the obvious observed fact. One of thefew exceptions is Hou, Mead, and Nagahashi (2005). Weproposed that the origin of China’s reform can be traceddirectly to the food crisis resulting from the early years ofthe Cultural Revolution, Mao’s siding with the pragmatism

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of Chow Eng-lai, the failure of Lin Biao’s “coup” attemptat the Lu-shan conference, and the second food crisis as aresult of the transfer of partial authority to the local gover-nors and military leaders.

Soon after, China formally abandoned the “self-reliant”policy on food. This can be further seen in many aspects ofChina’s policy towards the outside world. The ping–pongdiplomacy (which was such a major event that it evenmade its way into the Oscar winning movie “Forest Gump”)focused on major agricultural exporting nations (the U.S.,Canada, Australia, Argentina) or those with chemical fertil-izer technology (Japan), and the fact that 19 of the first 38contracts for “imported” plants to china in the year follow-ing the U.S.–China rapprochement (1972) were facilities forthe production of chemical fertilizers.11 This clearly repre-sented a much more pragmatic attitude and a significantdeviation from the earlier idealism.

To further reinforce our belief, we took stock of China’srelationship with Latin America, especially in the 1970s.Here we see evidence that a dramatic shift in China’s centraldoctrine is underway. In addition to Cuba, China had signif-icant relations with four Latin America counties: Argentina,Chile, Mexico, and Peru. China started importing wheatand millet from Argentina to alleviate the effects of theGreat Leap Forward’s “Three Bad Years.” Chile was underthe Allende’s Marxian regime and was able to supply wooland fertilizer that China needed. Peru was the first SouthAmerican country to establish diplomatic relations withChina and this relationship was further strengthened afterthe military coup of Juan Velasco Alvarado when the newgovernment nationalized many U.S. owned corporations,causing the U.S. to cut aid and discourage investment andimports. China was able to absorb part of Peru’s exportsand minimize the impact.12 Under President Luis Echever-ris, Mexico tried to reduce its dependence on the West inorder to strengthen its own position in the world marketand the political scene and looked towards socialist coun-tries in an effort to better its bargaining position with itsneighbor to the north (the U.S.). Trade between the twocountries, Mexico and China, also increased significantlyfrom under $1 million in 1971 to $52 million in 1977.13

The above relations are natural and perfectly alignedwith the original Chinese doctrine of “exporting” revo-lution. What followed in the late 1970s, however, is notso consistent as the Latin American political landscape

of entire plants, often with some technical advisors attached.12 During 1960–1970, overall trade between China and Peru was less

than $1 million. Yet, in 1971, the total trade reached $58 million. Peruvoted for the admission of China into the UN in 1971.

13 Echeverris not only supported China’s admission to the UN, he alsogave a strong speech advocating the expulsion of Taiwan in 1971.

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ommunist regime of General Videla. Yet, China choseo maintain both political and economic ties with theseations in total departure from its previous patterns. Thesehanges clearly demonstrate China’s dramatic alteration ofts foreign policy from ideological purity to economic prag-

atism. This external aspect grew in tandem with China’snternal efforts to change the economic incentives for agri-ultural production (Fei & Hou, 1994; Hou, 2004), whiched to the full fledge economic reform by 1979. One canence conjecture, China’s reform may not have started withblue-print, but it was also not simply due to the “initial

ondition.”Furthermore, theory (e.g. Fei and Ranis model) has

uggested that in the path towards industrialization, theroductivity increase in agriculture was the prerequisite.his was seen in the fact that the 17th century “agricul-ural revolution” preceded that of the famed industrialevolution. The success of the rebuilding of Japan, thendustrialization of South Korea and Taiwan were all pre-eded by land reform which led to dramatic increasesn agricultural productivity. This allowed the agriculturalector to fulfill their “historical missions”: create agricul-ural surpluses to feed the non-agricultural population, toelease surplus labor to be employed by the industrial sec-or, provide finances for industrialization and the marketor industrial output. This is well documented for TaiwanHou & Appleton, 1996; Kuo, Ranis, & Fei, 1981).

This leads to another question: could and should havehe Russians intentionally focused on the agricultural sec-or to achieve the needed agricultural “contribution”? I doot think so. Unlike China, the former Soviet Union is madep of many different Republics with different languagesnd different culture. There was also deliberate (perhapsased on comparative advantage) compartmentalizationf production in the Soviet central planning. For example,s Russia is highly industrialized, Ukraine was made thebreadbasket” for Russia. This may be part of the reason forhe aforementioned disparity between Russia and China’sinitial condition”.

The “disadvantage” of the Russians runs deeper thanhis. Even if they had a large non-agricultural sector, andven if they took a lesson from China by being patient (grad-alism) and started with the agricultural reform, it wouldot have mattered as they lacked the soft capital of his-ory, cultural, and tradition. China has had a long history of

arket-oriented farmers, while the Russian peasants wereffectively serfs to the manor before the 1917 revolution.

. Culture, history, and the invisible side ofconomics

Economists, especially the younger generation ofestern-trained scholars, have been mesmerized by the-

retical mathematical models. In such models, time ismplicit, adjustment is almost instantaneous, and the exis-ence of markets is accepted as given (hence the problem

aised in Section 2). Furthermore, economists as a profes-ion, even when we discuss our theory and models in theontext of a specific economy, we have mostly ignored theistory and cultural aspect of what we are studying. This

s perhaps what prompted Solow (1986) to dismay that a

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universal “general” theory is a dead-end, and each case is“specific” in nature. Indeed, as a profession, we need to beacutely reminded that we are, after all, a social science.

With this in mind, I pondered what are the majordistinctions between China and Russia (historically andculturally) that would be relevant in explaining the differ-ence in their current economic performance. One of thefirst aspects that came to mind is the length of whicha Communist State Economy was in place. The People’sRepublic of China was established in 1949. During the ini-tial transformation, public and private ownership coexistedtill 1956. The Comprehensive Economic Reform was offi-cially adopted in 1979 (Central Committee, 1979). Thus,the centrally planned communist economy was in placeless than two and a half decades. The significance ofthis is that the industrialists and entrepreneurs that werepresent before the Revolution were still alive, and themarket culture can thus be (relatively speaking) easilyrevived.

In contrast, the Bolshevik revolution was in 1917 andlasted till the early 1990s, spanning more than sevendecades. If the industrialists/entrepreneurs existed in Rus-sia prior to the revolution, they would have been deadby the time Boris Yeltsin became the Russian President. Ifone takes a second look at Russia under the Czar, one hasto doubt whether such industrialists/entrepreneurs everexisted, or existed in a large enough number to form ameaningful social class.

In 1861, Czar Alexander II enacted the EmancipationEdict, which abolished personal serfdom (freeing one thirdof the population). The peasants were to receive landfrom the landlords, but with payment. The governmentadvanced the payment to the landlords and was to recoverit from the peasants via 49 annual payments. As a tem-porary arrangement (before the system was set up), thepeasants paid “temporary obligation” directly to the land-lord in terms of labor or monetary means. In many places,this “temporary obligation” dragged on for more than twodecades. Many peasants were forced to accept “beggarlyallotments” (i.e. 25% of the prescribed amount) in exchangefor eliminating the monetary payments, while others wereforced to pay more than the worth of the land.

To make things worse, the Russian peasantry was orga-nized into communes (mir), which controlled village life.The mir was responsible for redemption payments andperiodically redistributed the land to meet the changingneeds of the various households. Thus, though peasantscould and do own private land, only 14 million hectareswere truly privately owned while 151 million hectares ofland in European Russia were owned and farmed collec-tively in 1910. Though there were nominally changes interms of land ownership, it did little to improve produc-tivity as peasants did not really “own” the land and hencehave no incentive to improve land quality or try new meth-ods/crops.

Despite the disadvantages of the mir system, the peas-

ants preferred it as they felt it guaranteed everyone a fairshare of the land. But true to the Malthusian theory on pop-ulation, this “improvement” caused a population explosionas it doubled between 1861 and 1910. Despite the size ofRussia, only 2 million of her 15 million square kilometers of

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land (both European and Siberia) are suitable for farming.This population explosion meant that the average allot-ment dropped from 5.24 hectares in 1961 to 2.84 in 1910.The West experienced similar population explosions, butwas absorbed by the rapid growing industrial sector; thiswas not available to the Russians.14

The peasants were in a permanent state of expectation(expecting the land promised to them would be given tothem). When it became obvious that this was not going tohappen, their allegiance (to the Czar) wavered. It was in thisenvironment that the Socialist Revolutionary Party, andlater the Bolsheviks, was able to win the popular supportof the peasants in 1917. Despite this, it must be recognizedthat the peasants in Russia are extremely conservative.They simply switched from a feudalistic manor system toa commune run by the mir. They have never been ableto dictate their own destiny, and perhaps never wantedto.

In contrast, China has had a market-orientedentrepreneur peasant class for over a thousand years.China has had a well-structured farming structure basedon variations of the “well field” system for over twomillennia. The land is “owned” by the State, and is givento the peasant family to cultivate. The peasant pay taxesin the form of grain (mostly rice), while others paid theirtaxes in kind (e.g. carpenters paid taxes in the form ofservices in building/maintaining government offices).15

This system depended on a large quantity of land and ameticulous record of land lots (hence the famous “fishscale” books).

This all changed in the tenth century (Sung Dynasty,960–1279 a.d.), as population outgrew the land. Landbecame private property and tax payment changedfrom rice to money. This freed up the peasants fromsingle-mindedly planting rice to utilize comparativeadvantage and plant crops with maximum yield and profit.The emergence of this market-oriented, profit-seekingentrepreneur/peasant class was a major breakthrough inChina’s economic development. Not only was this able toincrease agriculture productivity, it had a far more pro-found impact on the Chinese Economy, which broughtChina to the brink of “commercial” capitalism.

The root cause is the change in land ownership, andmore importantly, the payment of taxes. As tax paymentschanged from rice to money, this stopped the “institu-tional” flow of rice to the North. In its place, a class oflong-range rice merchants arose. They would travel thou-sands of kilometers to the South, buy rice and transport it to

the North. This had a tremendous multiplier effect both interms of economic institutions and economic activities. Tofacilitate trade (for both safety and convenience), checks ormoney orders (ying-piao) and money houses (chien-zwun)

14 The industrial sector was only able to absorb about one-third of theexcess rural population, despite the costly efforts of the reform policy ofWitte.

15 <fn0075>This is why in the Disney movie “Mulan”, the heroine’s dis-abled father was called up for military duty when the barbarians invaded.He was paying his taxes. Mulan’s family was a military family, whichreceive a rice stipend in peacetime, and goes to war to pay their taxeswhen the need comes.

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emerged. These early forms of commercial banking greatlyreduced the cost of transaction.

The shipping of such large quantities of rice/grain wasno simple task. Land/water transportation industries blos-somed, as well as security services. The surge of merchantsand travelers brought about commerce, food, lodging, anda variety of business along the trading routes. Such rad-ical changes lead to, or were facilitated by, changes ingovernment. It is the Sung Dynasty that established polit-ical, social, economic, and cultural patterns that remainedlargely unaltered in China for a millennium. A new group– the scholar-gentry class, whose power came from land-holding and long years of educational training, replaced theold aristocratic domination of government.

Interestingly, it was the further weakening of the SungDynasty (the Southern Sung) that brought about evenfurther advances. As Northern China fell to the invadingbarbarians, the Sung Court and many of the literary gen-tries fled south. For the (by then) established gentry class,they were able to bring their wealth in the form of moneyand other precious material, but land was immobile. With-out a stable and perpetual source of income (land rents),these gentries that fled south were forced to engage in com-merce. The importance of this event is the general upgradeof the human capital of the merchant class, and the totalintegration of Confucianism into the very fabric of society.

Contrary to Weber (1930, 1964), I believe Confucian-ism is not a hindrance towards capitalism, but promotehard work and disciple that is essential to the formationof entrepreneurship spirits. Indeed, Confucianism is muchlike the Protestant ethic that Weber saw as the prerequisitefor the Industrial Revolution, and the reason that Webercame to a conclusion to the contrary is due to his misunder-standing of many of the Confucian teachings (Hou, 2010).Indeed, if one looks at the success of Japan, the four smalldragons, and China, the most important common thread isConfucianism or the Chinese culture.16

During the 10th and 11th centuries, in addition to thechanges in land ownership and tax payments, agriculturealso benefited by the introduction of new, early-ripeningstrains of rice. Combined, food production was greatlyincreased, this released labor from the farming sector andthe food surplus allowed the support of a growing non-agriculture city dwelling social structure; much like theagriculture revolution of 17th century Europe that wasthe precursor to the Industrial Revolution. In China, thesechanges led to the rise of cities and enormous advancesin commerce. Cities based on trade and industry mul-tiplied rapidly, especially along the southeastern coast,the Yangtze River valley, and the Grand Canal that lednorth. Indeed, the specialization of agriculture propelled

the nation into a semi-national market in many goods,combined with the fact that the gentry class were forcedto engage in commerce, the capitalistic entrepreneurs hadbecome part of Chinese culture.

16 For a more formal discussion of gentry, culture, and capitalism inChina, refer to Yin (1987) and Yu (1987). The effect of Confucianism andChinese Culture on neighboring nations, please refer to Hou (2010), andLiao (1983, 1985).

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In addition, starting from the latter stages of this periodSung Dynasty), China’s seafaring also took on grandercale. As well stated in the labor literature (e.g. Borjas,987), those that chose to migrate such long distances areot your average people. They tend to be the more deter-ined, industrious, and most certainly with extremely

trong entrepreneur spirit. The success of overseas Chineses an extremely vital asset, which is something a semi land-ocked nation like Russia cannot compare. The serfs had noight to move, and even with the communes (the mir) suchobility and entrepreneur spirits were certainly not easy

o foster.Both China and Russia were not particularly strong in

erms of industrial capitalists. Indeed, up till the early 20thentury, both were dominated by foreign-owned industriesperating within their political borders. But here, Chinagain held the advantage. The Bolshevik revolution effec-ively ended any opportunity for the development of aussian capitalist class. The turbulent years of the 1930sill the end of WWII were important to the emergencef the capitalist class in China. In an effort to preparehina to (inevitably) combat the Japanese, the National-

st government intentionally fostered such industrialists.nequivocally, these were the “privileged” class and were

nevitably corrupt,17 but the eight year war against Japan,nd the Western powers relinquishing there economic holdn China (as a way to “thank” the Chinese war effort), didreate an industrial capitalist class.

. Role of the State

Up to now, I have deliberately avoided a direct discus-ion of the role of the State, and the differences between thewo reforms in this aspect. It is not because I do not deemt as important; rather it is precisely because of the pivotalole that the State plays which compelled me to place itere as I move towards the end of my analysis.

If one takes a short stroll through history, the activeole of the State is everywhere; be it the living gods ofgyptian Pharos, the Athenian Empire through the Delianeague, and the Caesars of Pax Roman. If we examine moreecent history, the State intervention under Mercantilism isbvious, and its political residue (i.e. the effects of colonial-sm) continues to haunt us. Even for the model of modernemocracy (the United States), it would not have survivedxcept for the strong willed central government (demon-trated by the action of Hamilton) in the early stages.

The laissez faire ideal of the invisible hand requiresumerous mature and functioning institutions. Never-heless, the belief that “Government is not the solution.overnment is the problem.” (President Reagan’s 1980

naugural Address) has had a profound influence politicallynd academically for over two decades. It is only reasonable

o assume that this philosophy had its effect on the post-oviet era Russia. The exact reason why this had no majorffect for China is unclear. The cautious nature of the Chi-ese reformers (see Section 3) is not only an explanation,

17 These, among other issues, gave the CCP (Chinese Communist Party)platform that was very popular to the general public.

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but also a fact that when this Reagan saying was publicized,China was already many years into its reform attempts.18

Combined with the reality that the reform measures haveshown concrete effect, there certainly was no reason toabandon the role of the State.

In contrast, when the Russian reform began in earnest,the Reagan quote was already part of pop language anda political ideology for over a decade. Furthermore, it ismy belief that Boris Yeltsin really did not have any plan orstrategy to deal with the post-Soviet Russia economy. Thus,when Sachs advised the Russian President on liberalizingthe economy and let the market take over, Yelstin eagerlyagreed. In reality, rather than categorizing this as “liberal-ism”, it is perhaps better characterized as abandonment ofresponsibility of the State.

This leads to a fundamental issue: what is the role of theState (both academically and from a social populist point ofview)? Most economists that believe in market mechanismwill suggest that when faced with minor or even moderateeconomic disequilibrium, it is best to let the invisible handtake its course. However, with the exception of perhapsthe most hardcore laissez faire economists, when faced withtruly severe economic crisis we (just like the general public)turn to the State for guidance and assurance. As a metaphor,we like the role of the State to that of a medical doctor.When one has a minor cold, we either let it take its courseor use over-the-counter medication to relief the symptomand/or speed up the recovery. But, when we are severelyill, doctor is looked upon as God or at least our savior. Per-haps an even stronger description (still using doctors as ametaphor for the State) is to relate to children. To ensurethe safe birth of a new-born, the doctor’s role in prena-tal care, pregnancy delivery, and the ensuing pediatric careare vital. These increase the odds of survival, and set thefoundation for a longer and healthier life afterwards.

If one adheres to this example of human life and drawparallels to economic development, the importance of theState in the early stages of development is inescapable.Without exception, all economies lack the market mech-anism, low in efficiency, insufficient funds, and have highrisk in the early years. In this sense, there is an absoluteneed for the State to “supply” development capital. For bothChina and Russia, the logical route is to develop large busi-ness, as the existing SOEs are by nature such firms. Thisis perhaps best characterized as moving towards a “publiccapitalism” (in the Gailbraith tradition), where social struc-ture is based on a complementary relationship between theState and big corporations, with the integration of socialinterest with market efficiency as the end objective.

Typically, the State takes on the role of “giving birth” tolarge corporations, and when these companies are mature,they then take on the task of assuring the achievement ofState objectives; similar to the ideal relationship between

parent and children. Such “child rearing” can take on manyforms. It could be a direct incorporation into the realmof government (Taiwan’s national monopolies), or directpublic financing (the chebols of South Korea). It could take

18 This is if you accept the argument made by Hou et al. (2005) thatChina’s reform really began in the early 1970s.

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the form of indirect public planning where the State deter-mines the budget for public investment and then distributeamong different “national” industries (e.g. France), or via asemi-competitive auction where large companies receivepublic financing for specific State related projects (the U.S.and U.K.).

Regardless of what form it takes, this relationshipimplies that the State and the large corporations jointlydevise, manage, and implement long term strategies forboth their domestic and external markets. A perfect exam-ple is the export subsidy and foreign exchange rebate thatChina used to encourage production and obtain hard cur-rency in the mid/late 1980s (through the early 1990s).Prices were still “unreasonable” due to government control,and the over-valued RMB implied that SOEs lacked compet-itiveness in the international market. The State providedexport subsidies to the SOEs to offset the high RMB, theforeign exchange earned (which was mandatory sold to theState) aided the State in acquiring needed imports, whilethe portion of foreign exchange the exporting SOEs areallowed to retain serve as economic incentive to becomemore efficient.

Under this Public Capitalism, the State and big businesscooperate to achieve the main objectives, and in doing soprovide a stable and rule-adhering environment, which isthe desire of both State and business.19 Such an environ-ment is in the interest of the State, firms, and the generalpopulation. The only people that would dislike such anarrangement would be illegal business. Illegal activities willalways exist, but in an economy where the State is weakand rules are either lacking or inconsistent, it fosters suchillegal business activities. That is perhaps why the unorga-nized semi-illegal sector in Russia accounts for up to 50%of the economic activity.20

This is especially true in the financial sector, as theRussian economy is notoriously under-monetized. In aproperly “monetized” economy, total bank deposits shouldbe 15–20% of GDP (China is in excess of this), but this fig-ure is merely 7% in Russia (Li, 1997). This implies that thebanks are unable to provide financial services vital to busi-ness, and this is indeed one of the major problems plaguingthe Russian economy since the 1990s. As a measure of howthis has severely handicapped the performance and marketvalues of the business sector, let us quote some numbers.The top 200 industrial firms in Russia had a total marketvalue of that is equivalent to 40% of the value of GeneralElectrics. Or, another perhaps even more depressing fig-ure, the top 7 firms in Taiwan has a market value that is47.5% of the top 200 Russian firms.

Not only has China not had this problem, it is further

blessed with the huge source of capital inflow from over-seas Chinese. The fact that Hong Kong and Taiwan are thelargest and fourth largest FDI into China (Hou, 2004; Hou& Zhang, 2001a, 2001b), respectively, is testament to this.

19 This is exactly what Hou (2008) meant by a “negative” institution costas it reduces the cost of production.

20 It is generally acknowledge that the “organized” illegal activity (i.e.the Russian mob) has a significant hand in many aspects of the economy,but actual numbers are hard to come by.

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Russia does not even come close in this aspect. If one looksat the broader picture and examine the issue of FDI, thedifference between Russia and China could not be more dif-ferent. According to Ksenia Yudaeva (Centre for Financialand Economic Research, Russian Federation), Russia hasfew legal limits on FDI, but public policy creates a climateeffectively hostile to such investment. “We want foreigndonors to come to Russia,” lamented Yudaeva, “not for-eign investors.” While limits on FDI do exist in China, theyhave welcomed it in practice, reaping tremendous benefits.Since the 1990s, China has been the largest FDI destinationamong developing nations, and the second largest over-all (behind the U.S.). But in 2003, China surpassed the U.S.and was the largest recipient of FDI, and the growth is onlygoing to be more impressive as China’s FDI related lawscontinue to become more liberalized and the markets moreaccessible (per WTO rules).

Returning to my metaphor of the State being a doctorbringing a new child into this world, China certainly hadthis, while Russia is woefully lacking. Using yet anothermetaphor, China’s economy grew under the paternalistic(Gailbraith, again) and watchful eye of Deng, Jiang/Zhu, andthe current leadership of Hu/Wen. In contrast, the Russianchild was effectively abandoned by Yeltsin. Though a nur-tured and loved child is not guaranteed to grow up to bea productive adult, but the odds are astronomically betterthan a child left to fend for itself in the wild.

However, as I stated in my opening statement at theConference on Reform and Development in Deng’s China(Miller Center for Government, University of Virginia,1992),

“In the early stages of the reform, it is vital to have astrong central government. The State has to play the roleof a traffic policeman, directing who to stay and whoto move. Otherwise, the impatience of those involvedwill inevitably result in chaos and traffic gridlock. How-ever, it is equally important for political reform to gathermomentum and not lag too much behind. Otherwise,much like a person leaning forward (progress in eco-nomic reform), if the legs or political reform do not catchup, one will eventually fall down.”

This, perhaps, is the only dark cloud hanging in the hori-zon. Ironically, this is precisely the edge that Russia mayenjoy if it can ride through the current turmoil.21

Another more pressing issue is foreign exchange andthe financial sector. Russia had liberated State banks andimplemented currency convertibility. China, on the otherhand, facing the WTO imposed deadline for financial lib-eralization has a tough road ahead. Some argue that thisperhaps is a positive result to come from the shock ther-

apy for Russia (though I do not agree, as will be discussedlater). By liberalizing the prices, they are (theoretically)freed from the threat of “structural” inflation (due to price-rigidity in the downward direction, plus needed changes

21 Indeed, Srinivasan (2008) came to the same conclusion that eventhough China is ahead of India in practically every aspect, but the demo-cratic political institutions in India may allow the slow Indian elephant toovertake the China dragon in the long run.

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n relative prices), which was perhaps the cause of China’s994 inflation (Chang & Hou, 1997). By 2006, inflation wase-emerging, and the question was whether the currentremier (Wen Jiabao) has the same determination of thehen Premier Zhu Rongji to bring it under control. Of course,hat became a mute point as the subprime crisis broke.owever, that was a short reprieve as combating inflation

s the top priority in China once more.

. State, institutions, and transmission costs

I hope I have make a convincing argument regarding theivotal role of the State during the transition of a Socialisticconomy towards a market-regulated system; much likehe importance of an attending physician during prenatal,irth, and early childhood. Now I would like to extend thisiscussion of the role of the State to a mature market econ-my, much like ours. Obviously, the reader can sense I amrying to tie-in the government action (or in-action) thated to, during, and perhaps long after the subprime crisis.

I am not here to argue about the merits of the marketconomy, or the efficiency of the invisible hand. Though Iave made clear my reservations regarding the neoclassicalheory based on mathematic models. It is not just that these

ath models implicitly assume instantaneous adjust-ents, but they also lack the dynamics of institutional

volution. This latter issue is my focus in this final segment.In the process of economic development, since the nat-

ral environment is static, the only things that can interactith the economic activities of mankind are the institu-

ion framework or institution factors. This is why Newmerican Institutionalists such as North (1990) poignantlyrgued that “Integrating institutions into economic theorynd economic history is an essential step in improving thatheory and history”.

The institution factors that must be considered in thenderstanding of economic activities is more than mereconomic institutions (which would include the “relationsf production” of Marx), as it also deeply involves theolitical and social aspects. Generally speaking, political

nstitutions are aimed at governing and hence have sta-ility as its main objective; while economic institutionsre more individualistic and have development (con-inued improvement of the standard of life) as its topriority. In contrast, political institutions are static, whileconomic institutions are relatively dynamic. Equilibriumxists only when the two are consistent. And only underuch equilibrium will the political and economic sidese complementary and mutually beneficial. Unfortunately,istory has demonstrated that such equilibrium is typicallyhort-lived, unless the political institution can also becomeynamic.

Rather than say that the economic institutions areynamic in contrast, one might say that the economicgent’s pursuit of individual well-being is the source of

otion. Thus, the real dynamics is “man’s efforts to sat-

sfy his wants”, which, in turn, interacts with institutions.orth (1990) further defined “institutions” as followed:

“Institutions are the rules of the game in a societyor, more formally, are the humanly devised con-

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straints that shape human interaction. In consequencethey structure incentives in human exchange, whetherpolitical, social, or economic. . . . Institutional con-straints include both what individuals are prohibitedfrom doing and, sometimes, under what conditionssome individuals are permitted to undertake certainactivities.”

The key point for my purpose is that institutions are the“rules of the game”, which directly affect economic costsand hence economic activity. Typically we only count thecost of inputs and the cost of transportation in the calcu-lation of production costs. After Coase (1960) introducedthe concept of transaction costs, the traditional productioncost is becomes merely “transformation cost”; the factorcost associated with the transformation of inputs to out-put, or the transformation of nature and appearance; whiletransportation cost is the transformation of location andownership of the good.

North (1990) presented a clear definition of this trans-action cost, “consists of the costs of measuring the valuableattributes of what is being exchanged and the costs ofprotecting rights and policing and enforcement of agree-ments.” Of which, “the costliness of information is the keyto the cost of transacting” and that “these measurementand enforcement costs are the sources of social, political,and economic institutions.” Wallis and North (1986) calcu-lated that the market related (e.g. banks, insurance, finance,wholesale, retail, etc.) transaction cost account for 45% ofU.S. GNP in 1970, while a hundred years ago it was only25%. This clearly states that most of the transaction costsare expenditures via the market.

Hence, North argues that production cost is the sumof transformation and transaction costs, and that institu-tions mostly affect the latter. I believe that another costalso stems from institutions, which I shall term as “trans-mission cost”.22 This cost comes in both an explicit and animplicit form. In a sarcastic metaphor, the explicit trans-mission cost is very similar to the “protection” fee thathoodlums extract from local merchants. Since transforma-tion and transaction activities can only be smoothly carriedout under the protection of institutions (be it formal orinformal), production units must pay explicit dues to thegoverning institutions. This can be in the form of taxes,fees, or the initiation fee and annual dues of unions or simi-lar organizations. These explicit expenditures are aimed atthe maintenance and operation of the transaction or eco-nomic institutions, and hence can be viewed as the “explicittransmission cost”.

As for the implicit transmission cost, it does not haveto take the form of monetary, in-kind, or labor activ-ity; it is mainly the side effect or byproduct of economicpolicy implemented by the government. Due to this

tion/transaction cost when positive, and lowers them when

22 The more appropriate term should perhaps be “institution cost”, butthe choice of transmission cost is to parlay into a “trans” trilogy of trans-formation cost, transaction cost, and transmission cost.

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negative. In some aspect, this implicit transmission cost isan “externality”.

It may be argued that in North’s definition of trans-action cost, it already includes “costs of protecting rightsand policing and enforcement of agreements”, which issimilar to the proposed transmission cost. This criticismis not all together fallacious. However, if we make thesame logical argument, then transaction cost is alreadyincluded in the traditional production/transportation costs,as producers and wholesalers/retailers must do businesswith banks/insurance/financial businesses, and must hirelawyers/accountants to “protect rights and police andenforce agreements.” Coase separated such expendituresfrom the production/transportation costs and called it“transaction” cost, as the nature is different from the “trans-formation” costs. Here, the focus is on the effect of politicalinstitutions on economic institutions, and hence classifytransformation/transaction costs as expenditures stem-ming from market activities, while those expenditures thatare independent of market activities and are somewhat“involuntary” as transmission costs.

Strictly speaking, the above comment only applies tothe explicit transmission cost, as the implicit cost is notrepresented in either transformation or transaction costs,though its importance sometimes surpass that of theexplicit transmission cost. This can be best illustrated withspecific historical examples. After Chin united China (221b.c.), “Land rent and the tax on salt and steel was twentyfold of the past.” (“Book of Food and Commodity,” His-tory of the Han Dynasty), implying a drastic increase inthe explicit transmission cost component of the total pro-duction cost; while “the legal setting of measurements,unifying the width of carts, and common written char-acters” demonstrate the “negative” implicit transmissioncost, as they lowered both the transaction cost (commonmeasurements and language) and the transformation cost(common width of carts reduced transportation cost andcommon measurements reduced input costs). However,the suppression of the mercantile class such as the “forcedmigration of one hundred and twenty thousand wealthyfamilies to Hsienyang (capital of the Chin dynasty)”, andthe “sending . . . merchants to attack the south of the FiveRidges [i.e. Kwangtung]” (both from “Biography of the FirstEmperor of Chin”, The Chronicles) represent the additive or“positive” implicit transmission cost, as they prohibit cap-ital formation and led to management inefficiency, thusraising the transformation costs.

The explicit transmission cost is mainly payments togovernment (in the form of various taxes), this is whythe early Confucian philosophers advocated low taxes andminimal labor duties, so as to lower transmission cost andother forms of production costs. From a more modernperspective, the larger the amount of resources that thegovernment command, or the larger the percentage of theGDP accounted for by government expenditure, the largerthe explicit transmission cost. On the other hand, the more

government restrictions on economic activity, the largerthe implicit transmission cost, as it will clearly raise thetransformation and transaction costs. It is thus obvious whyAdam Smith greatly advocated laissez faire, and proposesthat the role of government should be limited to national

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defense, judiciary and social order, so as to allow economicagents to achieve full efficiency via competition, which inturn will minimize the transformation/transaction costs. Inmodern language, it is “liberalization”, or the withdrawalof political powers from the economic arena (Hou, 1997).

However, this round of subprime crisis has led manyto believe that this liberalization has gone too far. Indeed,many developing nations and transitional economies arenow expressing doubts in the efficacy of market system.This is perhaps most evident in China, as the role of the Statehas taken a big step forward (or backwards, depending onone’s perspective) in controlling the overall operation ofthe economy, and many worry that it is a step backwardsin China’s continued reform (Tian, 2010). I am not advocat-ing the expanded role of the State, but I do believe that theState must play an expanded role in the times of extremecrisis, just as the case for economies in transition, as arguedearlier. Back to my example of the medical doctor as ametaphor for the State. When the patient is facing a life-threatening illness, few would not turn to their doctor andput their own welling being in the hands of the doctor.

Since institutions structure the incentives in humanexchange, it plays a major role in human economic activi-ties. The main economic impact of institutions is to “reduceuncertainty by establishing a stable (but not necessar-ily efficient) structure to human interaction.” Despite itsmany ills, the State has the power to directly restruc-ture the political institutions, which in turn affect theeconomic institutions by changing transmission costs andhence inducing the restructuring of economic institutions.However, in terms of the pursuit of stability, political insti-tutions are far more intense than economic institutions. Itis plain to see why. In order to maximize long term bene-fits (be it private/personal or societal), the ruling class (beit democratic or authoritarian) must hold on to power andassure political stability. That is why, though all institutionsare static by nature, political institutions are even more sothan the economic ones, thus making the latter dynamicin contrast. This is also why when “equilibrium” occurs, itis short-lived by nature, as one set of institution is static,while the other is dynamic. Only when political institutionscan serve the need of economic institutions (i.e. become“dynamic”), can the two (sets of institutions) maintain arelatively long-lived equilibrium.

Most people believe that the democratic polity exhibitsmore of this desirably dynamism, but this is still debat-able. For economies in transition (and perhaps for LDCsalso), a concerned and benevolent State should be workingdiligently to guide the economy onto the path of generalprosperity, and may be more efficient in doing so. Arrow’sImpossibility Theorem (Arrow, 1950) showed that underdemocracy, social justice and efficiency is impossible toachieve. This echoes Plato’s argument in The Republic thatDemocracy is unsustainable (the other forms of unsus-tainable States are (Timocracy, Oligarchy, and Tyranny).Ironically, the ideal state outlined by Socrates closely

resembles a Tyranny in structure, but the (philosopher)king who rules in the ideal State is not self-centered butis dedicated to the good of the State.

The discussion of political institutions is far beyond myexpertise, and hopefully this paper leads to more focused

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iscussions by my colleagues in Political Science, or otherisciplines that may provide more insight. Nevertheless, ife take a quick look at the response to the current crisis by

he U.S. and China, some interesting facts emerge. Like the.S., China has undertaken massive fiscal stimulus totalingMB 4 trillion, or $586 billion. This is smaller than the U.S.timulus of $787 billion. However, in relative terms, the008 U.S. stimulus was 5.54% of the 2008 real GDP, whilehe 2008 Chinese stimulus was 13.53% of the 2008 Chineseeal GDP. It is estimated that China has the fiscal abilityo carry out a 2nd round of stimulus, while the dire bud-et situation in the U.S. need no further discussion.23 Inerms of outcome as measured by the 2009 GDP, the U.S.eal GDP growth rate was −2.6%, compared to a 9.1% forhina (CIA, The World Factbook, 2010). Democracy versusocrates’ ideal State?24

As social scientists, it is easier for us to start a talk; it isuch harder to bring it to an end. I will do so by returning

o the subprime crisis. In its ‘Declaration of the Summitn Financial Markets and the World Economy” November5, 2008), leaders of the Group of 20 cited the followingauses25:

During a period of strong global growth, growing cap-ital flows, and prolonged stability earlier this decade,market participants sought higher yields without anadequate appreciation of the risks and failed to exerciseproper due diligence. At the same time, weak under-writing standards, unsound risk management practices,increasingly complex and opaque financial products,and consequent excessive leverage combined to createvulnerabilities in the system. Policy-makers, regulatorsand supervisors, in some advanced countries, did notadequately appreciate and address the risks building upin financial markets, keep pace with financial innova-tion, or take into account the systemic ramifications ofdomestic regulatory actions.

To further bring in the point, let me return to North.orth pointed out that institutions does “structure the

ncentives in human exchange”; however, it can also beaid that man’s pursuit of survival and development struc-ure the incentive of economic institutions. This is to say,o survive and to improve life, man must engage in eco-omic activities, and since man is a societal animal, some

orm of rules of the game must be imposed to ensure theontinuation of such activities. And thus economic institu-ions are born. It is precisely this insatiable urge to improve

ne’s living that leads to the faster paced and more frequenthanges in economic institutions relative to the politicalounterpart, thus making it the main source of social evo-ution, and comes into conflict with the stability (or status

23 This dramatic fiscal difference is not just due to the political institu-ions. One needs to remember that unlike the U.S. government (whichs a “pure” government), the Chinese government is also the largestandowner and the biggest entrepreneur.24 It is perhaps a stretch to call the CCP General Secretary Hu Jintao andremier Wen Jiabao as benevolent philosopher kings, but such inferenceay not be as absurd as one may think.

25 The “Group of 20” is made up of Finance Ministers and central bankovernors of the G20.

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quo) oriented political forces. Due to the static nature ofpolitical institutions, it can only hold the line in defense.However, when economic institutions evolve to a certaincritical point, this line of defense will be breached, and anew political institution that is consistent with the con-temporary economic institutions must be established. Insuch, the political and economic institutions are once morecomplementary, and a new equilibrium is reached.

Is there a better description of what, why, and how thesubprime crisis came about? Who is to blame? There isenough blame to go around. On Wall Street and in the finan-cial industry, moral hazard lay at the core of many of thecauses. Moral hazard occurs when a party insulated fromrisk behaves differently than it would behave if it were fullyexposed to the risk. This was caused by greed, ignorance,and recklessness, but the inadequacies of the political insti-tutions must bear the majority of the blame. It is not myintention to discuss what is the optimal or even appropri-ate role of the State (or the form of the State); my intentionis to remind us that the State has a role in as much as settingthe political institutions that which change transmissioncosts and hence economic behavior and activity.

For us, social scientists, it is our role to ponder, research,discuss and debate what the political institutions shouldbe, how the economic institutions ought to be. It is not thatmathematical–theoretical models are of no relevance, butto quote yet another Nobel laureate, Stigler (1965), “Thebasic role of the scientist . . . is that of establishing thecost and benefit of alternative institutional arrangements.”And to add my two cents, these institutional arrangementsshould be aimed at minimizing positive transmission costs(which increase total economic cost of production) andmaximize the negative transmission costs. In the perspec-tive of the current crisis, the increased regulation andscrutiny will undoubtedly raise the transmission costs. But,if it reduces moral hazards, lowers long term risk, andreduces the probability of such crisis from recurring, is itnot a “negative” transmission cost that will decrease theeconomic cost over time?

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Arrow, K. J. (1986). History: The view from economics. In W. N. Parker(Ed.), Economic history and the modern economist (pp. 13–20). NewYork: Basil Blackwell.

Borjas, G. J. (1987). Self-selection and the earnings of immigrants. Ameri-can Economic Review, 77(4), 531–553.

Central Committee. (1979). Regulations on the work in rural people’s com-munes. Issues and Studies (reprinted (in English) in two parts in August1979 (pp. 100–112) and September 1979 (pp. 104–115)).

Central Committee. (1984). Decision of the central committee of the CCPon reform of the economic structure. Beijing Review (reprinted (inEnglish) in the October 29, 27 (44)).

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