Why do nations fail, and is China exceptional?

This year’s Nobel Prize for Economics, awarded to Darren Acemoglu, James Robinson and Simon Johnson, recognised the work done over two decades to explain why some nations succeeded in getting richer, and others failed, at least relatively. While abstract and mostly mathematical models of economic growth have held sway in this space, the contribution of these three economists to the understanding of economic and human development focuses instead on the role played by robust economic, social and political institutions.

According to the authors, inclusive institutions, which provide for property rights, equal protection before the law, neutral contract enforcement, and human and social rights and obligations, encourage investment in, and the development of, both human and physical capital. Extractive institutions, designed only to benefit the elite, do not. The sequencing flows from good governance to better economic outcomes, not the other way round.

In the wake of the award, the accolades were generous, and fair in spite of some differences in professional judgment concerning methodology and technique. Yet, as one might expect, some academics were viscerally critical, asserting that the authors betrayed a Western or capitalist bias on which institutions are effective, even condemning their work for, in effect, validating colonialism. Many critics repeated doubts about the worthiness of the institutions argument because, as they say, it struggles badly with the sustained rise of China. But does it?

The last point on China is certainly a more substantive challenge to the idea that democratic forms of governance and inclusive institutions are the ticket to enhanced prosperity. While the Chinese Communist Party (CCP) has certainly experienced huge political changes since the People’s Republic was founded, it has always been Leninist, controlling, and more or less repressive. For all of that, China registered uniquely double digit economic growth over the 30 years to 2010. Its GDP is now 65 per cent of the US, or ten times what it was in the 1980s. In terms of income per head, China has made less dramatic progress, but it has nevertheless grown from one to two per cent of the United States to almost 19 per cent.

Those who hail China as the antidote to an institution-led analysis, however, should be careful not to overplay their hand. China’s best years of economic progress were the result of the Reform and Opening Up initiative launched by Deng Xiaoping in 1978, and pursued mostly – with a hiatus following the 1989 Tiananmen protests – until Xi Jinping came to power in 2012. This campaign gave a political blessing to some separation of party from state, private initiative and privatisation, liberal reforms, civil society institutions, and international exchanges. Importantly, it also introduced markets and prices into key parts of the state-led economy, and substituted the institutionalisation of law and rule-making for diktat and decree.

These were the things that lifted hundreds of millions out of extreme poverty, and laid the framework in which China’s economy was able to erupt, bringing great prosperity to some, and creating the now fabled Chinese middle class. China’s productivity performance, which is the holy grail for prosperity, correlates well with the different periods of reform and the moves toward more liberal and inclusive governance.

Yet, as if to underscore the Nobel-winners’ point, economic progress did not make China more liberal or democratic politically. Then, as the government backed away from the key tenets of Reform and Opening Up from the 2010s, China engaged with a more pernicious cycle of economic backsliding and greater repression. With Xi Jinping’s penchant for party discipline and purity, centralisation of political, economic and social control, and the subjugation of private enterprise to the party state, China’s economic performance has faltered and revealed a political stasis about what to do with China’s economic model.

We should note, too, that although China maintains a 30 per cent share of global manufacturing and a central position in global supply chains, and has recognised areas of technological leadership and dominance, its successful industrial policy derives not so much from comparative advantage, as defined by Smith and Ricardo, but from repressive institutions in which workers have few rights, health and safety standards and corporate pension obligations are weakly enforced, private and foreign firms are expected to serve their customers and the interest of the party state, and designated firms benefit from vast subsidies, cheap credit and other favourable arrangements. In short, mercantilism rules.

Indeed, the relevance of institutions to China’s development prospects could not be more topical, as it wrestles with a host of systemic economic problems, which also present acute and awkward political policy problems. Economic growth and productivity have slowed down significantly. The economy is characterised by severe debt constraints, a real estate bust, a chronic weakness in demand, high youth unemployment and a dearth of good job opportunities, social malaise, and a private sector and middle class lacking in confidence.

These issues have been stalking the economy for a few years, and the government has been trying to address them in piecemeal fashion for a while, especially since Covid. Such is the current angst that it has decided on more radical measures to try and stabilise or boost the economy. In late September, it announced a large package of measures designed to ease monetary and financial conditions, boost the stock market, and offer yet more assistance to the housing market. In October, it promised additional borrowing to help relieve the stress in cash-strapped local governments, which are the agents that deliver public goods and services, and bolster the capital positions of banks under the deadweight of bad loans. Further announcements spelling out the so-called ‘fiscal space’ the Chinese authorities will use are expected soon.

The government can certainly buy a bit of time as it tries to stabilise the economy and housing market, and borrow more to help out local governments and banks. Yet these policies, even if Beijing were to approve, are not going to address the root causes of China’s economic problems. What is missing from these palliatives, is a root and branch programme of economic reforms, which, unfortunately for the Chinese government, require political reforms and new attempts to open up and liberalise China’s institutions. These will be mostly impossible for a Leninist government to endorse.

To illustrate the dilemma, consider the thoughts of the prominent Chinese economist, Xiang Songzuo of Renmin University, who, asked to comment on the Nobel award, was quoted in the South China Morning Post applauding the authors and saying: ‘Only by moving forward towards further marketising our economy, emphasising the protection of intellectual property, private companies, fair market competition and upholding the spirit of entrepreneurship, can our economy attain sustainable growth and our people have higher incomes.’

He did not speak of China’s institutional arrangements as such, but his words speak to political and governance changes that would transform the nature of China’s legal, competition, regulatory, educational, social and other institutions, conferring rights and power where they are currently restricted or forbidden. The CCP is most unlikely to compromise on this. Peak China, if it hasn’t already arrived, may be closer than we might guess.