Time Of Adjustment - Russia vs. China

...the flaws in economic theory are many and varied. If there is one common theme, it is that the theory ignores the issue of time. Nowhere was this more apparent than in enthusiasm that Western economists had for Russia's rapid road to the market over China's slow and steady path. The story behind the tragedy of Russia's rapid road to the market provides an overview of the many reasons why China should continue to be sceptical about Western economic theory.

The outstanding difference between the transitions in Russia and China was the haste with which Russia undertook the task. This haste was encouraged by neoclassical economists, who advised Russia that the faster the transition occurred, the more effective it would be. One of the best-known economists involved in advising on the transition was Jeffrey Sachs, who is now Director of the Earth Institute at Columbia University. In a paper published in 1992, Sachs was emphatic that the only responsible pace of reform was high speed.

It might be thought that, since speed was such a key aspect of his recommendations, Sachs and economists like him must have modeled the impact of slow versus fast transitions and shown that the latter were, in model terms at least, clearly superior. But in fact the models from which economists took their guidance effectively ignored time. Rather than considering the time path that an economy might follow as the result of a policy change, these models presumed that the economy would move very rapidly from one equilibrium to another, and the time path of this change could be ignored.

This assumption of instantaneous change has been a key weakness of the dominant school of thought in Western economics since its inception in the 1870s. However, Russia was doubly unlucky that its period of transition coincided with the peak influence of the concept of “rational expectations” within this dominant school of thought. This intellectual fad took the neoclassical school's blasé approach to time to new and dangerous heights.

“Rational expectations” argues that consumers and producers in a market economy form their expectations in a rational manner—a statement that in itself seems innocuous. Of course there must be some people in an economic system who are irrational, but it would be foolish to assign much importance to their behavior when building a model of the economy.

However, what economists like Sachs meant by the phrase “rational expectations” was the ability to accurately predict the future of the economy.

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Even though rational expectations has since fallen from favour in the West, I expect those who once believed in it would protest that their views were more subtle than my summary implies. I beg to differ. Though they occasionally expressed some concerns, in general neoclassical economists advised that “economic agents” could rapidly adapt to any change that was thrown at them, and that the faster change was implemented, the better. Consider, for example, the discussion of how fast Russia's transition should be in a 1992 paper by the neoclassical economist Murray Wolfson. One of his suggestions was:

Central planners seemingly should at once resign their posts and close their offices. Their departure simply would signal the market to move immediately to equilibrium. (Wolfson 1992: 37; emphasis added)

Implicit in this statement was the proposition that all Russia had to do to create a market economy was to shut down its system of central planning. In fact, markets require enormous legal, political and physical infrastructure. This should be obvious to Western economists, who after all live in advanced market (or more correctly, mixed market-state) economies. But the neoclassical vision of a market is a simple village fair where farmers and artisans bring their produce in the morning, haggle over prices, and leave in the evening with all products sold. Neoclassical economists were therefore oblivious to the many tasks that needed to be completed before a workable market infrastructure would be in place.

The belief that market processes occur instantaneously is obvious in the statement that the end of central planning would “signal the market to move immediately to equilibrium”. Less obvious is the obsession with “equilibrium” itself. As I argue later in this book, the obsession is a large part of the reason why neoclassical economics provides such a poor model of a market system.

Wolfson's discussion of a gradual approach to the transition in this paper showed how much economists relied upon the “rational expectations” belief that people are omniscient(and how little a role time plays little in the thought patterns of neoclassical economists). His argument that a gradual program would fail relied heavily on the surmised actions of “rational and reasonably knowledgeable economic agents”. As I point out, by “rational” he meant what ordinary language describes as “prophetic”: how could people acquire so profound a knowledge of a system they have not yet lived in that they could predict its behavior (and prices in it) before it existed?

Wolfson's policy prescriptions were as didactic and extreme as his actual analysis was simplistic. He advised that:

A rational expectations conclusion is that quitting communism Cold Turkey is the only way to get from A to B. In practice, governments must make the national currency convertible and allow it to float on legal as well as black markets, abolish the system of subsidies and direct plans and quotas, close plants that cannot compete, come quickly to a privatization of industry even if some inequities result, strictly control the money supply, and allow goods and services to find their own price on national and international markets. (Wolfson 1992: 39)

Wolfson did qualify his arguments with some concessions to reality, but in the end his recommendations were all for speed on the basis of a belief in the self-adjusting properties of the market economy populated not by people, but by gods.

Wolfson is far from a leading light of neoclassical economics, but his views were typical of those who recommended upon and helped implement the actual transition, as George Stiglitz makes clear in his book Globalization and its Discontents. The actual process of transition was also more subtle than the simplistic propositions put by Wolfson, with some attempt to stage the introduction of change. But in general, Russia undertook a far too rapid transition. Away from the fantasies of rational expectations economics, what this rapid exposure to international competition did was give ex-Soviet consumers instant access to Western goods, and expose Russian factories to open competition with their Western counterparts.

A time-based analysis would instead have supported a gradual transition, if only to give Russian factories time to introduce modern production technology, products and process control methods. Time would also have been set aside for the development of the framework for distribution and exchange of goods in a market system: systems of wholesale and retail distribution, respect for written contracts, systems for consumer protection, laws of exchange, lines of credit, bankruptcy laws.

Unfortunately for Russia, given the haste with which the actual transition was implemented, the only market systems that could rapidly develop were those that were already in place in the preceding socialist system—the black market that had always been there to lubricate the wheels of the shortage-afflicted Soviet system, just as market intrusions once permeated the feudal systems out of which capitalism itself evolved in Europe. That gave the upper hand to criminal elements in the development of entrepreneurial activity in Russia, in marked contrast to the breadth of involvement in entrepreneurship in China.

...The Russia specialist Marshall Goldman put this in perspective with his discussion of the different importance given to the output of consumer goods in Russia and China. He noted that the Russian “experts” were more focused upon closing down inefficient state enterprises than boosting the output of consumer goods.

In contrast, China kept state enterprises running while increasing the output of consumer goods. These twin policies had several beneficial effects. Goldman provided a pithy summary of the difference between the road recommended to Russia by Western economists, and the Chinese road:

The Chinese experience demonstrates that shock therapy is not the only way to proceed. To the shock therapists who warn that step-by-step, gradual economic reform is like crossing an abyss in two leaps, the Chinese gradualists respond that economic reform should be like crossing a river by feeling for one rock at a time. (Goldman 1996: 210)