Capitalism from Below

Victor Nee, Sonja Opper

• Publisher: Harvard University Press
• Year: 2012
• ISBN:
  9780674070196
• Topic: Economics
• Subtopic: Development Economics
• Index: Economics

More than 630 million Chinese have escaped poverty since the 1980s, reducing the fraction remaining from 82 to 10 percent of the population. This astonishing decline in poverty, the largest in history, coincided with the rapid growth of a private enterprise economy. Yet private enterprise in China emerged in spite of impediments set up by the Chinese government. How did private enterprise overcome these initial obstacles to become the engine of China's economic miracle? Where did capitalism come from?Studying over 700 manufacturing firms in the Yangzi region, Victor Nee and Sonja Opper argue that China's private enterprise economy bubbled up from below. Through trial and error, entrepreneurs devised institutional innovations that enabled them to decouple from the established economic order to start up and grow small, private manufacturing firms. Barriers to entry motivated them to build their own networks of suppliers and distributors, and to develop competitive advantage in self-organized industrial clusters. Close-knit groups of like-minded people participated in the emergence of private enterprise by offering financing and establishing reliable business norms.This rapidly growing private enterprise economy diffused throughout the coastal regions of China and, passing through a series of tipping points, eroded the market share of state-owned firms. Only after this fledgling economy emerged as a dynamic engine of economic growth, wealth creation, and manufacturing jobs did the political elite legitimize it as a way to jump-start China's market society. Today, this private enterprise economy is one of the greatest success stories in the history of capitalism.

1

Where Do Economic Institutions Come From?

The emergence and robust growth of a private enterprise economy in China was neither envisioned nor anticipated by its political elite. In launching economic reform in 1978, the initial motivation was to address failures of central planning within the institutional framework of state socialism. The political elite approved reform policies in order to stimulate productivity in a command economy weighed down by years of lagging economic performance. With their continuing emphasis on public ownership, the post-Mao reforms seemed nothing other than an ambitious project to shore up the state-owned economy in the aftermath of a calamitous decade of political turmoil. Compared to the sweeping changes under way in other transition economies, the Chinese reform seemed overly conservative, committed to restoration rather than transformative change. Contrary to expectations of economists in the West, however, China’s economic reforms gave rise to a thriving market economy.

Why did a dynamic private enterprise economy and institutions of capitalism emerge in China? How could entrepreneurs overcome formidable barriers to entry enforced by government? What are the institutions that allow private economic actors to compete and cooperate in a transition economy still dominated by government-owned firms? And where did economic institutions of capitalism come from? Standard economic theory does not offer ready solutions explaining China’s path to capitalist economic development.

In implementing the party’s reform policies, the central government sought to improve incentives by decentralizing and cutting back on state control of economic activity. In agriculture, reformers decentralized production to the peasant household through a land-lease system and promoted the gradual liberalization of rural markets. In industry, reform measures sought to strengthen material incentives for management and workers through retention of profits and more enterprise autonomy. In parallel, the state promoted foreign direct investments (FDI) to alleviate capital constraints and to speed up the country’s technological catching-up process. Reform leaders implemented fiscal decentralization to strengthen economic incentives for provincial and local government through a revenue-sharing arrangement. Though lower-level governments have the obligation to submit a fixed proportion of fiscal revenues to the higher level of government, they retain the residual for their own budget.1

In Eastern Europe and the former Soviet Union, following the collapse of Communist Party–led governments, economists representing international economic agencies gathered in capital cities to advise the political elites of the newly established governments on how to design and build the economic institutions of capitalism. These political elites sought, through a rapid sequence of top-down reform measures, to promulgate the formal rules and regulatory structures of market capitalism in line with policies recommended by the International Monetary Fund (IMF) and the World Bank. The rationale for a “big bang” transition, emphasizing rapid, large-scale privatization, price liberalization, and currency reforms, rested on assumptions about the entrenched nature of central planning as an economic order. In the view of many economists in the West, only shock therapy would do the job of breaking away from the powerful entrenched interests and all-encompassing grip of central planning, rapidly providing a legal framework as the institutional foundation of a market economy.2 China’s piecemeal economic reforms appeared destined to fail, they thought, while the bold reform measures under way in Eastern Europe and the former Soviet Union promised in short order through “big bang” transitions to institute free-market capitalism.

Within thirty-odd years, however, China’s per capita gross domestic product (GDP) calculated at current prices has increased more than thirty times in spite of rapid population growth. Starting out from a nominal per capita GDP of only $150 at the start of reforms—at that time ranked 131 in the world—China entered the group of upper-middle-income countries with a registered per capita GDP of $4,603 in 2010.3 The effects for social and economic well-being were pronounced. Since the beginning of economic reforms, average life expectancy rose by five years to seventy-three years in 2009, even exceeding that in upper-middle-income countries.4 Income inequality increased rapidly after an initial decline, and is on par with that in the United States; even so, economic reforms have benefited all income groups.5 Between 1981 and 2005, more than 630 million Chinese left absolute poverty (based on the benchmark of $1.25 per day for consumption), which reduced the fraction of population living in poverty from 81.6 to 10.4 percent, establishing a record for poverty reduction in human history.6

The rise of a privately owned manufacturing economy has played a key role in wealth creation and has changed China’s industrial landscape dramatically. By 2009, only around 20 percent of the gross industrial output value in domestic production was generated by fully state-owned and collective enterprises. Forty-one percent accrued to private companies registered as partnerships, limited liability companies, or shareholding firms. In addition, 25 percent accrued to limited liability companies of mixed ownership, and 13 percent to shareholding corporations of mixed ownership (including stock-listed firms.)7 Private enterprises secured 40 percent of industrial profits, and employed 47 percent of the industrial workforce registered in domestic-funded companies.8

Why were China’s economic reforms, envisioned as a restoration project, more effective in fostering market-driven structural change and economic growth than the sweeping reforms undertaken by political elites in Eastern Europe and Russia, which closely followed policy recommendations of the IMF and World Bank? Why did the private enterprise economy, initially so disadvantaged, not only survive but thrive in China’s transition to a market economy?

The State Remaking Economic Institutions

Many observers point to the prominent role of central and local government to explain China’s successful transition to a market economy, now in its fourth decade of transformative economic growth. Whether this is described as the helping-hand government, local state corporatism, or the developmental state, there is an underlying notion of the government’s decisive role in devising and shaping the emerging institutions enabling and motivating China’s economic miracle.9 It is generally thought that China’s development mainly rests on a state-directed process of institutional change, wherein efficiency-enhancing formal rules and policies are instituted by political elites.10 Although the trial-and-error character of economic reform has been widely acknowledged, analysis interpreting the successes and failures of China’s market transition tends nonetheless to focus on political actors in central or local government. Various studies document how local government officials used their regulatory and financial power to successfully advance local economic development through infrastructure investments or through local industrial or technology parks.11 Even regional analysis of adaptive institutional change rarely focuses attention on initiatives by entrepreneurs and firms, but on the role of local governments, which, substituting for missing national legislation, provided temporary regulations that protected private firms against local state expropriation. Wenzhou Municipality, for example, a southern coastal city in Zhejiang Province that lacked a Maoist-era industrial base, responding to local commercial activities, put in place local private firm regulations already in 1987, one year before the central government launched a first official document to regulate private firms.12 Wenzhou officials also established local policies guiding and promoting entrepreneurial activities, including a simplified taxation system. Local policies there and elsewhere fostering “adaptive informal institutions” suggest that the government’s acquiescent attitude often played a supportive role in those localities, where the marginalized private sector could rapidly develop, in spite of missing formal institutions safeguarding private property rights.13

Building on the view that the polity, as the enforcer of the rules of the game, is “the primary source of economic performance,” state-centered analysis underscores the role of political actors.14 The idea that politicians play a key role is both substantively undeniable and intuitively appealing. With its monopoly of the use of legitimate violence, the state enjoys substantial cost advantages in institutional change. By contrast, the free-rider dilemma constrains the ability of economic actors to assume the cost of collective action to establish and enforce the rules of the game. The political elite’s interest in revenue maximization motivates the exchange of public goods provision for tax revenue, which in turn aligns elite interest in sponsoring formal institutional change to promote economic growth.15

In departures from central planning, instituting the formal rules of a market economy necessarily comes first, in this view, because the polity can change formal rules virtually overnight. Informal constraints are not only slow to change, but also beyond the reach of the political elite.16 They are seen as a source of friction working at cross-purposes to the political elite’s effort to implement institutional change.17

The Limit of the State-Centered Explanation

The problem with the state-centered approach, however, is that it cannot explain the emergence and self-reinforcing growth of China’s robust private enterprise economy, by now a central component of the manufacturing economy. During the first decade of reform, though the central government encouraged household businesses (geti hu), it explicitly sought to restrict private commercial activities to a peripheral role. To the extent that the government implemented regulations to legitimize private firms, it was in a spirit of tolerance of a necessary concession, allowing marginalized social groups—rural households, the unemployed, laid-off and retired workers—to start up small-scale production, but not providing active support or a level playing field. If the political elite had had their way, the seeds of capitalism, sowed as an unintended consequence of reform policies, would have been contained by state-mandated rules restricting the size of private firms to individual household production, which would have stayed in the traditional mode of making small-scale commodities for the market. This form of household production flourished in all preindustrial societies, as in the traditional putting-out system in the West before the rise of modern capitalism. Both Karl Marx and Max Weber noted that it is a self-limiting form of traditional economic organization.18 In their accounts, the modern capitalist enterprise did not develop from traditional household production.19

In the early 1980s, the political elite envisioned the household firm as an organizational form promoting self-employment for marginal economic actors at the periphery of an economy dominated by state-owned enterprises. Local government freely issued licenses to start up household-based private firms to farmers producing for urban markets, traditional merchants, artisans, peddlers, and educated youths returning to the city from years in the countryside. The political elite did not anticipate that large numbers of start-up firms would grow quickly into sizeable manufacturing enterprises even before the government formally acknowledged the registration of larger private companies in 1988.

In many areas, politicians surreptitiously allowed the larger private firms to register legally as collective enterprises formally owned by local government, though the founding capital was private and actual firm operations did not involve regular government participation in management. Such “red hat” firms laid the basis for a thriving private enterprise economy in Wenzhou, for example.20 Local governments received in return a management fee, typically specified as a certain percentage of after-tax profits. Other entrepreneurs attached their business to established collective or state units as so-called hang-on households (gua hu). Under these arrangements, entrepreneurs paid a fee for the use of the name, stationery, and bank account numbers of the registered public firm.21 However, such disguised forms of private firms remained vulnerable to expropriation by local governments through special taxes and mandatory contributions to community projects. The predatory taxes and expropriation by local government and the looting of assets and wealth of peasant entrepreneurs highlighted the problem of insecure property rights.22

It was not until a decade after the start of economic reform, when private enterprise was already growing rapidly, that the first constitutional amendment (Article 11) in 1988 eventually conferred legal status to private firms. The corresponding national regulation—“The Temporary Regulations of Private Enterprise” (July 1988)23—governing private firms with more than seven wage laborers (siying qiye), however, still reflected the government’s intent to limit the private sector to a subordinate if not inferior role, as the sector was officially viewed as a supplement to the socialist public-owned economy.24

The constitutional change recognizing the legality of private enterprise fell far short of conferring social legitimacy and secure property rights upon entrepreneurs. No explicit central government policy enhanced or facilitated the founding of private firms. Quite to the contrary, market entry remained costly. The Administration of Industry and Commerce (the formal supervisory bureau of private firms) in Beijing, for instance, required 443 approval items for registering a private firm.25 The taxation system further deepened the sector’s competitive disadvantage. While the maximum tax rate for collective enterprise was 55 percent, the corresponding rate for private firm income reached 86 percent.26 Tax exemptions ...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright
• Dedication
• Contents
• List of Figures and Tables
• Acknowledgments
• 1. Where Do Economic Institutions Come From?
• 2. Markets and Endogenous Institutional Change
• 3. The Epicenter of Bottom-Up Capitalism
• 4. Entrepreneurs and Institutional Innovation
• 5. Legitimacy and Organizational Change
• 6. Industrial Clusters and Competitive Advantage
• 7. The Development of Labor Markets
• 8. Institutions of Innovation
• 9. Political Economy of Capitalism
• 10. Conclusion
• Appendix 1: Firm Surveys
• Appendix 2: List of Interviewees
• Notes
• References
• Index