How to Make Economic Policies Work in a Transitional Economy

How to Make Economic Policies Work in a Transitional Economy *

Justin Yifu Lin
China Center for Economic Research, Peking University

    The theme of conference is on the effectiveness of macroeconomic policies. As someone participating in a number of macro-policy discussions in China, I’d like to provide some inputs to the discussions from the angle as a practitioner, that is, how to make theories work in a developing country, especially a transitional economy likeChina.

    Compared to the macroeconomic theories that I learned as a PhD student in Chicago in the 1980s, I found most of those theories based on the rational expectation now have either been revised or discarded due to their failure to explain or predict the observed macroeconomic phenomena in the past decades. The failure arose from the inadequacy of their specific institutional, structural or behavioral assumptions. Now the old theories have been replaced by the new theories. However, the new theories’ ability to explain or predict the real world phenomena also depends on their institutional, structural and behavioral assumptions. There are many new theories. Based on their different institutional, structural or behavioral assumptions, the new theories often give contradictory policy recommendations. For example, the real business cycle theories would oppose any government’s attempt to smooth a business cycle, whereas the new-Keynesian theories would support such attempts. Among these new theories, some of them may perform better in certain periods of time in certain countries. Nevertheless, as someone from a transitional, developing country, I would have to say even if a new theory might perform very well in the developed countries and there were consensus that it was the valid theory, it should be cautious when we try to apply that theory in the developing economies because of the differences in institutional, structural and behavioral conditions between the developed and developing economies.

    A theory’s ability to explain and to predict depends on whether its assumptions are reasonably consistent with the real world conditions. If we want to apply a theory, even the most advanced one, we need to pay attention to what kind of conditions are required for the validity of that theory in the real world and whether or not those conditions exist in the developing country. I’d like to use two policy debates that I participated in China last year to illustrate what I mean.

    China encountered a period of deflation in the period from 1998 to 2002. Like deflations in other countries, the consumer price index and retail price index continued to fall year by year. To fight against the deflation, the Chinese government adopted a Keynesian type of proactive fiscal policy. By the time of 2003, the Chinese economy seemed to have got out of deflation because the consumer price index increased 1.2%, compared to that last year, and the retail price index was only negative 0.6%, meanwhile the annual GDP growth rate increased from an average of 7.8% to 9.1% in 2003.

    Under such a macroeconomic situation, we had an interesting debate in the second half of 2003 and the first quarter of 2004 among academic circle in China. Some economists argued that the low inflation with dynamic growth in 2003 was the best macroeconomic outcome and the government should not adopt any intervene policy. If there was any policy to take, it should be to phase out the proactive fiscal policy. However, some economists, including myself, said “well, in the discussion of economic situation in the transitional period of China, we should not only look into the aggregate numbers, we needed to understand the disaggregate numbers as well.” For example, why we had a 9.1% GDP growth rate in 2003? The main reason was the sharp increase in fixed asset investment of 26.7%, measured in real term. Moreover, the investment concentrated on three sectors namely, real estate, which increased 29.7%, automobiles, which increased 87.2%, and the construction materials, for example, the investment in steel mill increased by 96.1% and in cement increased by 121.9% as a result of sharp increase in demand due to the rush in real estate and automobile investments. The inflation was low because the majority of sectors in Chinese economy still had huge capacities. According to the Chinese statistics, there have 16 categories of goods and services in the retail price index. In 2003, the price index in twelve sectors continued to fall for about 100 months continuously. Only four categories prices increased. They were food, energy, construction material and gold and jewelry. Under such a situation, if the government had followed the policy recommendation from standard macroeconomics and have not taken any actions, the investment rush in real estate, automobiles and construction materials would have continued. When the investments completed, those three sectors would have had huge excess capacity and the deflation in China would have become even worse than that in the period of 1998-2002.

    This policy debate started in the fall of 2003, it continued for about 9 months. Only by the time of April 2004, aconsensus emerged. In 2003 the investment rush was mainly in the coastal area, and in the first quarter of 2004 the investment rush sprayed to the whole China. In that quarter the fixed asset investment in the eastern part of China increased 47.8%, the central part of China increased 53.2% and the western part of China increased 52.3%. By that time everyone was convinced that we needed to take some actions otherwise the excess capacity situation in the future was going to be worsened.

    However, when the consensus for a proactive action was reached, another debate arose again. One policy recommended by many economists in China and abroad was to adopt a market instrument, that is, to raise interest rate. The argument was that the interest rate was the cost of investment. The raise of interest rate would increase the cost of investment and slow down the investment. In addition, in the first quarter of 2004, Retail Price Index increased to 2.8%, and for the one year fixed deposit, the interest rate was only 1.98%. Therefore, it was necessary to raise interest rate in order to avoid a negative real interest rate for the deposit. 

    Other economists argued that we had to take some administrative measures instead of raising interest rate. I belonged to this school although I graduated from the University of Chicago. The main reason was that we needed to understand the motivation and the institutional setting behind the investment rush. For the real estate investments, many of them were speculative. The expected returns for such investments were so high as long as the investors could capitalize the gains before the burst of bubble. The investors understood the bubble was going to burst someday and they wanted to borrow as much money and complete their investments as fast as possible therefore the raise of interest rate would not stop their speculation and investment. For other type of investments, even though they may not be speculative, the situation in China was very similar to the situation in Korea before 1997. That is, in the investment rush of 2003 and early 2004, 90% of the funds for investments came from bank loans. Under such a situation, they had the mentality of soft budget constraint. If their investments could make money, they would return the loan. If their investment could not make money and the projects turned bad, they could easily take back the 10% of their money away and leave all bad assets to the banks. Under such a situation it is very important for the government to take a policy that controlled directly the investments in the targeted sectors in order to check the investment rush.

    Withstanding a lot of pressures, the government followed the second approach and only in November 2004, the government raised the nominal interest rate by 27 basic points. The result was quite remarkable. In 2004 China’s Consumer Price Index was 3.9%, Retail Price Index was 2.8% and GDP growth rate was 9.5%.

    To conclude, theories are very important for the design of policy, but the validity of theories depends on institutional and behavioral assumptions. If we ignore the institutional and behavioral differences, when we saw China’s macroeconomic situation in 2003, we might advise the Chinese government to take no action; and when we came to a conclusion that some action was desirable in 2004, we might recommend the standard interest rate policy instead of a sector-oriented administrative control. Certainly it is important to learn the development experiences in other countries and to learn the new advancements in the economic theories. But paying attention to the institutional assumptions for the validity of theories and the institutional, structural, behavioral conditions for the success in economic development in other countries are the most important requirements for creative application of theories and other countries’ successful experiences and for designing macro stability policies for sustaining development in developing countries.

* Remarks at the General Panel, the Bank of Korea Conference on the Effectiveness of Stabilization Policies, held in Seoul, Korea on May 27, 2005..