Efficient market, effective govt

The Decision on Major Issues Concerning Comprehensively Deepening Reforms, issued by the Third Plenary Session of the 18th Communist Party of China Central Committee on Nov 15, says "the basic economic system should evolve on the decisive role of the market in resource allocation", for which it is essential to establish a "proper relationship between the government and the market".

The change in the market's status in the economy, from playing a "basic role" to "a decisive role", is important. The Third Plenary Session of the 14th CPC Central Committee had defined the "basic role" of the market in 1993. By redefining the market's role, Chinese leaders have exhibited their determination to deepen all-round reforms.

History tells us that the key to a country's long-term development is better handling of the government-market relationship. After the end of World War II, many economies started pursuing modern development to narrow the gap with developed economies. But most of them failed to realize the goal. Only two succeeded in advancing from low-income to high-income economies; one is Taiwan and the other is the Republic of Korea. Besides, only 13 economies have completed the transition from middle-income to high-income societies since World War II.

In terms of development economics, the economies that failed did not handle the relationship between the government and the market well. The essence of development is constant increase in the average income level, which requires increasing labor productivity led by more advanced technologies. Developed countries benefited from the industrial revolutions and technological advancement with high investment risks and returns. Their income, on average, increases by 2 percent and economic growth by about 3 percent a year.

Developing countries, on the other hand, can use the "latecomer advantage" of low investment risk and high returns. If this advantage is well used, they can have a growth rate double or triple that of the developed countries.

But why have most developing countries failed to use the "latecomer advantage" to boost their modernization drive? Two strategies can be blamed for that. The first is the wide use of structuralism by these countries in the 1950s and 1960s, which made the government's role supreme and ignored the role of the market in resource allocation. As a result, the heavy industries built with government resources performed poorly, further widening the gap between the developing and the advanced economies. The second is the prevalence of neoliberalism in the 1970s and 1980s that overemphasized the market's role and neglected that of the government in resource allocation, creating a far worse crisis.

The few economies that realized their development goals have one thing in common: they built an efficient market and an effective government at the same time.

Only an efficient market can establish an efficient price signal, which leads to full and free competition. And only an effective government can improve the infrastructure to promote technological innovation and upgrade industries, which are prerequisites for economic development. In short, the market and the government both play key roles in a country's economic development.

An effective government is extremely important for countries in transition such as China. First, the lifting of preferential policies for enterprises and industries that do not enjoy any comparative advantage could lead to their collapse. And only an effective government will be able to maintain such policies. Second, countries in transition usually invest all their financial resources in advanced capital-intensive industries, which for want of finance and logistics are plagued by poor infrastructure. And only an effective government can coordinate and complete the superstratum system to help the market realize stable and healthy development in the long run.

China's economic development history since the opening-up in the late 1970s proves the importance of the government. In the initial stages, the government applied a dual-track system, providing certain protection measures and subsidies to large State-owned enterprises, and allowing the market (with the help of private capital) to play a key role in labor-intensive and small-scale traditional industries.

Also, the government has made continuous efforts to improve the infrastructure and provide more institutional guarantees. As a result, the Chinese economy has seen an average growth of 9.8 percent in the past 34 years, which is unprecedented in history.

But at the same time, the rapid growth has exacted a heavy price: widening income gap and corruption, making deepening of reforms all the more important.

China is no longer a country of extreme poverty. In 1978, China's per capita income was only $155. But it reached $6,100 in 2012, making China a middle-income country. So the government needs to change some of the preferential policies and encourage more competition. Which means the market should play a more important role in the economy and the government should take stricter measures to protect property rights and the environment, and to solve external issues. If the relationship between an effective government and efficient market can be properly handled, China will enjoy smooth economic development with 8 percent annual growth for another 20 years and enter the high-income group.

The author is the honorary dean of the National School of Development, Peking University, and State Council counselor. The article is an excerpt from his recent speech at Peking University.