Central planning at work?

Photographer: Kevin Lee

China Is a Communist Success Story. Kinda.

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Here's a fairly common discussion you see on Twitter or hear at cocktail parties:

Libertarian: "Communism doesn't work!"

Acquaintance: "Oh, yeah? What about China?"

Libertarian: "China, communist? Ha! They started to succeed when they opened up to free enterprise, and then they kept it going by privatizing the state-owned enterprises. China is a capitalist success story!"

Our libertarian friend has a point. China's dramatic growth began in the 1980s, just after the government's sweeping program of pro-market reforms. China decollectivized agriculture, allowed private business and opened up to trade -- and the economy took off.

But while we shouldn't downplay the importance of the private sector in China's success, we shouldn't overplay it, either. Our libertarian friend's case isn't quite as persuasive as he thinks it is. In particular, we need to take a closer look at those state-owned enterprises, or SOEs.

That's exactly what economists Chang-Tai Hsieh and Zheng Song do in a new working paper, "Grasp the Large, Let Go of the Small: The Transformation of the State Sector in China." The title of the paper is taken from a Communist Party slogan coined in 1999, when China began transforming the SOE sector. Hsieh and Song find that the reality of SOE privatization is far different from the potted free-market anecdote that we like to tell ourselves.

First, many of China's state-owned businesses weren't actually privatized at all! What happened was that they were listed as private companies, allowing outside investors to own stock in them. But the government retained majority ownership, meaning that the government could always call the shots. For example, Baoshan, a Shanghai steel manufacturer, is at least 75 percent owned by BaoSteel, which is wholly government-owned. In reality, Baoshan is a state-owned enterprise, but in the official figures it's counted as a private company.

Then there are murkier cases. For example, Qingdao Haier -- one of China's most famous appliance makers -- is 46.5 percent state-owned. Theoretically, that's a minority stake, though it seems to stretch credibility to think that the remaining 53.5 percent could ever overrule a government decision. The company has reportedly been forced to acquire unprofitable companies on occasion, which is the kind of thing you would expect a state-owned enterprise to be forced to do. PC manufacturer Lenovo is majority-owned by private investors, and its chief executive officer insists that it is a "market-oriented" company, but the Chinese Academy of Sciences owns a significant minority stake.

So the "privatized" SOEs are often not really privatized. But this hasn't stopped them from doing well -- Baoshan, for instance, made a $940 million profit in 2014.

As for the SOEs that were closed after 1999, Hsieh and Song find that many were shut simply because they were unprofitable. Many smaller SOEs were allowed to survive, and many larger SOEs were consolidated into conglomerates. This isn't the free market -- this is central planning.

And central planning appears to have worked, at least for a while. Following the reforms, the labor productivity of the remaining SOEs rose to equal that of private-sector companies. Although the SOEs continued to use their capital very inefficiently, total factor productivity -- a measure of companies' overall efficiency -- rose faster at SOEs than at private companies!

In other words, the history of China's state-owned enterprises is actually a success story for communism, not capitalism. Once in a while, it seems, a government really is nimble enough and motivated enough to manage a big chunk of the economy.

Our libertarian friend isn't going to be happy to hear that. But he can take comfort in the fact that eventually, free markets will beat centralized control. In his 2000 book "Can Japan Compete?," Harvard strategy professor Michael Porter and his Japanese co-authors recounted the story of Japan's industrial policy in the 1960s, 1970s and 1980s. They found that Japan's government often engaged in industrial policies much like those of China's government with its SOEs -- encouraging companies to merge, trying to direct which markets they entered and so on. While these industrial policies met with some success for a while, eventually they almost all backfired, causing Japanese companies to lose market share once their costs rose.

China is no doubt a model to many people and governments who hope that the logic of capitalism can be overcome. But it may be a mistake to regard it as a communist success story, because the story isn't over. China's per capita GDP is only about $13,000 per person -- still much lower than in Japan, the U.S. and other rich countries. When you're poor, catch-up growth is easy -- just force your people to save money, force those savings into investment and copy foreign technology. Even with a partly communist system, you might not do too badly.

But once you reach the point where copying becomes harder and the return on physical capital falls, that might be when central planning starts breaking down, and some form of free markets -- whether the Japanese form, the French form or the American form -- becomes the only way to go. In other words, before we hail China as a model, let's see how rich it can get. If the continuing dominance of the SOEs slows China down before it reaches the income of rich countries, then our libertarian friend will have reason to smile after all.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net