Economic Reforms in Russia and China as seen in advance

By John Ross

China and Russia have recently become relatively fashionable subjects of economic analysis
- notably as two key components of BRIC (Brazil, Russia, India, China). Their importance is,
however, far greater than that.

China and Russia are two of the largest economies in the world. They have combined
populations of almost one and a half billion people. Together they occupy a large part of the
world's landspace.

Both China and Russia emerged from centrally administratively planned economies but then
they underwent the most diametrically counterposed economic developments in history.
China experienced, in the last thirty years, the most rapid economic growth ever witnessed
in human history. Russia underwent the greatest decline in GDP ever seen in any country in
peacetime.

Events of such economic magnitude evidently merit the closest study. The lives of several
billion people are directly and indirectly affected by both the practical outcomes and the
theoretical policy conclusions drawn from such a scale of events. An economics that is
incapable of explaining such events, which are among the greatest scale of economic shifts
ever witnessed, is clearly not an economics adequate to explaining the real world.

The article republished below is, therefore, reproduced in part to show that China and
Russia are not new objects of study for the author of this blog. And, more importantly, that
it was perfectly possible, with the right analytical tools, to foresee in advance the
counterposed outcomes in China and Russia of their respective 'economic reforms'. The
article's date of writing, spring 1992, drawing on articles written in 1991, shows that this
was not a retrospective rationalisation of events but a prediction of what was to come as
the 1990s unfolded in China and Russia. Its original title, 'Why the Economic Reform
Succeeded in China and will fail in Russia and Eastern Europe', is self-explanatory.

It is worth putting this article in its historical context. In January 1992 Russia embarked on
the economic reform policy known as 'shock therapy' – full price liberalisation accompanied
by the most rapid possible, and free, privatisation of state companies and assets. The
alternative course adopted by China, when it launched its economic reforms a decade and a
half earlier, was carried out without immediate full price liberalisation and without
privatisation of existing large scale state owned companies, and is described below.

The 'shock therapy' course was implemented by the then Russian government headed by
Yegor Gaidar, supported by the IMF, and advocated by journals such as The Economist and
Financial Times. These also held that China would lose as a result of carrying out a 'half'
reform compared to Russia.
The actual results, as noted, were the exact opposite - Russia suffered the greatest
peacetime fall of production ever suffered by any country, while China enjoyed sixteen years
of the greatest economic growth ever seen in human history.

It might be thought that such an outcome would have led to an abandonment of the
theories which had led to predictions that were refuted by events. After all in physics, or any
other branch of science, if a theory leads to predictions which are falsified by facts then the
theory is abandoned - and a theory which does predict the facts is put in its place.
Therefore, it might be imagined that those economists and commentators who had been in
error would now be studying and advocating what China had done right, analysing why the
policies pursued and advocated in Russia had produced such catastrophic economic decline,
and noting which wrong theories had led to this mistaken policy and why China, in contrast,
had pursued far more correct policies.

But in the real world, unfortunately, some branches of economics are more akin to
dogmatic theology than science: if a theory does not fit the real world then it is the real
world which is abandoned, not the theory. Such 'ostrich economics' might be mildly
amusing if wrong economic decisions affecting real people were not taken, and large sums
of money lost, based on such views. For these were not academic economic debates with no
practical consequences.

For it was, as shown below, entirely possible to predict in advance what would be the
consequences of the different 'economic reform' policies embarked on by China and Russia.
The views of those who advocated that the policies of 'shock therapy' would lead to success
and China would suffer in comparison, were simply falsified by facts. Those who argued, as
in this article, that China would enjoy success, and Russia would suffer economic collapse, as
a result of the policies adopted were vindicated by events. Sixteen years later there is no
longer any ambiguity as to the outcome.

But economic theory is about more than history. It analyses, or at least correctly carried out
it should analyse, material forces which in many cases continue to operate today.

It is evident that the economic tools deployed in the article below are not in themselves
unusual. They analyse well known, but different, types of market - monopolistic,
oligopolistic, and 'perfectly' competitive. They however do not assume that a homogeneous
market, corresponding to something approaching perfect competition, either exists or can
be created - a central fallacy of the theories which underlay 'shock therapy' and which
continue to misunderstand the Chinese, and indeed most modern, economies. The stress in
the article is how markets interact in a real economy.

Put another way, the article pivots around a single point: that an economic theory must
analyse the real world, the real world does not have to conform to an economic theory. The
attempt to apply a theoretical structure to an economy whose reality had little in common
with it, as in Russia at the time of the introduction of its new economic policies in 1992, led
to an economic catastrophe. The decision by China to ignore such advice, and to proceed
with an economic reform which corresponded to a real structure of its economy, produced
the greatest economic success seen in world history. The resulting differences were not
purely theoretical but have transformed the situation of the world economy.

A number of the key theoretical analyses used in this article, and related ones written at the
same time, therefore continue to be relevant to analysing the course of the world economy
and those of individual countries - and guide analysis in this blog. These include that:

 a market is not an abstract entity - something to be mystically mythologised as 'the

market' in a way that obscures its actual material features. Any actual market must
be analysed as a real structure - in which, for example, the different degrees of
competition operating in different parts of it, or in different interacting markets,
would produce different effects if essentially similar policies were applied to them.
 that in the long term the proportion of GDP devoted to fixed investment plays a
decisive role in economic growth rates. Indeed, provided that an international
orientation is adopted by the economy, historical experience shows that the overall
level of fixed investment is far more powerful in determining economic growth rates
than pre-occupation with attempting to achieve the highest possible marginal
efficiencies of capital via maximum market deregulation – for a detailed analysis of
this read here.
 that manipulation of relative prices, internationally via devaluation and similar
measures, or internally in China in the early period of economic reform via
controlling relative prices between the state and non-state, monopoly/oligopolised
and non-monopoly, economic sectors is a powerful tool of economic management.
That is, China showed that economic management can be carried out through
market mechanisms as well as by administrative controls - a lesson, in different
forms, China continues to demonstrate today.

One or two immediate policy proposals made in an article written sixteen years ago have
naturally been bypassed by changes in the intervening decade and a half. The economic
collapse of Russia post-1992 means that an incorrect distribution of investment, which at
that time failed to provide adequate consumption resources for the population, thereby
removing the material incentive to work and sharply reducing the productivity of capital due
to the perverse industrial structure which it created, and which therefore required a short
term transfer of resources into consumption, no longer exists. On the contrary, due to the
economic collapse in 1992-98, a key problem in Russia today is the inadequate investment
level. As the article notes: 'In China, where the economy was stable, investment was initially
reduced to create resources for extra consumption. However in Russia a precipitate
investment collapse is underway - the share of investment in the economy has almost
certainly already declined too much. The problem is therefore to stabilise and increase
investment.'

China's short term transfer of resources into consumption, via a short term reduction in
investment and a substantial cut in military expenditure, at the launching of its economic
reform - which was used to provide the initial demand for the development of its consumer
industries - has long since been bypassed. As the article notes: 'Over the 10 years 1978-88
reduction of the share of military expenditure in GNP was the chief means by which the
increase in the share of personal consumption in GNP was financed... The increase in the
share of personal consumption was initially financed by a reduction in the proportion of
fixed investment in GNP... After 1981, however, the benefits of reduced military spending
began to be felt, and the enormous increase in the share of personal consumption
necessary to bring about the initial change in economic structure could be reduced. .. By
1984 the percentage of fixed investment in GNP had regained its 1978 level. The dynamic of
the change on the demand side over the decade is therefore clear. Initially the proportion of
consumption was raised by reducing fixed investment. Then, as military spending fell, the
resources released were shifted into investment.' The proportion of China's GDP devoted to
fixed investment has continued to rise since, until it has now become the highest
experienced in world history – while simultaneously this has been accompanied by
continuously rising living standards.

This article below is considerably longer and more technical than those which normally
appear on this blog. The justification that is offered for this is the importance of the issues
dealt with.

Confronted with what is now the overwhelming evidence of the success of China's economic
reform, and the failure of the policies that were counterposed to it, there are only two
courses that can be adopted regarding the relation between economic theory and reality.

The first is to deny the real world. To, Canute-like, ignore the incoming waves of events and
declare that while China's economy has not failed 'yet' this is in fact just around the corner,
This is why the literature 'predicting' that China will suffer crippling economic crisis 'next
year' or in the short term - the prediction normally moving forward a year at a time, would
now fill several bookshelves. A typical example, chosen relatively at random, is the The
Economist's special supplement A Dragon Out of Puff: A Survey of China, dated 15 June
2002. This proclamation that China was 'out of puff', had the distinction of being produced
just as the country was about to enter the most rapid sustained economic growth seen in
human history – as those with an online account with The Economist can read. A large
subsequent, and preceding, literature of the same ilk can be produced.

Current predictions of 'deep crisis' in China are as invalid as the similar ones made in the
intervening 16 years since the events analysed below. China will inevitably encounter
various significant frictional problems in dealing with the consequences of the international
financial crisis. But China's economic fundamentals, launched by processes analysed in this
article, ensure that not only will it continue to be the world's most rapidly growing economy
but it will succeed in overcoming the current international financial crisis far more
comfortably than the US and Western Europe.

The second path is the economics of reality. To understand that China's economic reform
succeeded in producing the world's greatest ever economic growth for reasons that were
entirely comprehensible. And that the different outcomes of the course of deepening
'economic reform' pursued in China and in Russia were predictable in advance – because, as
will be seen, they were predicted in advance.

The article by the author of this blog originally appeared in Voprosy Economiki, in Russian, in
September 1992.
 ***

Why the Economic Reform Succeeded in China and Will Fail in Russia and Eastern Europe

Given that Russia, China, and Eastern Europe all share a common historic economic
structure any policy seeking a way out of Russia's economic crisis must confront a central
question. Why has the economic reform in China since 1979 produced the greatest
economic success in the world and the economic changes since 1989 in Eastern Europe and
January 1992 in Russia produced the greatest economic disaster?

This is not simply an academic question. In the last seven months the Russian government
has pursued a policy consistent with those followed in Eastern Europe for the last two and a
half years. [1] These policies have produced probably the greatest economic disaster outside
war in history. As the UN Economic Survey of Europe in 1991-92 notes regarding Eastern
Europe: "The cumulative drop of output registered over the last two to three years in some
countries has attained proportions that are unmatched even by the Great Depression of
1929-1933." Russia has suffered the greatest peacetime economic decline in its history. The
contrast between the results after the start of the economic reforms in 1979 in China, and in
1989 in Eastern Europe, as shown in the figures of the OECD, IMF, and World Bank,
illustrates the situation graphically.

- in the decade after 1979 Chinese Gross Domestic Product (GDP) grew at an average 8.8 per
cent per year. The Chinese economy more than doubled in size - expanding by 135 per cent.
In contrast Hungarian GDP fell by 11.7 per cent, Romanian GDP by 18.6 per cent, and Polish
GDP by 19.0 per cent. Czech Net Material Product (NMP) fell by 12.8 per cent, the NMP of
the former USSR by 16.0 per cent, and Bulgarian NMP by 30.9 per cent.

- Chinese industrial output expanded at an average 11.2 per cent a year. Chinese industrial
production nearly tripled in 1979-89 - increasing by 195 per cent. In contrast from the
beginning of 1990 to mid-1991 industrial output declined by 25.9 per cent in
Czechoslovakia, 27.2 per cent in Hungary, 38.1 per cent in Bulgaria, and 40.1 per cent in
Poland.

- Chinese employment increased by 3 per cent a year. Unemployment fell from 5.3 per cent
to 2.6 per cent. Labour productivity grew by 5.9 per cent a year. In contrast, between 1989
and the middle of 1991, employment fell by 11.6 per cent in Rumania, 13.8 per cent in
Czechoslovakia, 16.9 per cent in Poland, and 20.1 per cent in Bulgaria. As the fall in output in
Eastern Europe was even more rapid than the decline in employment productivity sharply
declined.

- In China growth of output of the most important goods for the Russian population - high
quality food and consumer products - was even more rapid than that of the economy as
whole. Total Chinese agricultural production expanded at 4.1 per cent a year. But sugar
production increased by 8.5 per cent a year, butter by 8.6 per cent a year, eggs by 10.5 per
cent a year, beef and veal by 17.0 per cent a year, oranges by 18.4 per cent a year, grapes by
19.3 per cent a year, and bananas by 21.9 per cent a year. Among consumer goods output
of cigarettes grew at 13.0 per cent a year, cloth at 13.8 per cent a year, televisions at 36.7
per cent a year, and refrigerators by 65.0 per cent a year, while average housing space per
person in rural China increased from 9.5 to 18.5 square metres. In contrast real wages fell by
20 per cent in Czechoslovakia and by 30 per cent in Poland.

- Even by the criteria the Russian government set itself, the promotion of private enterprise,
China has been far more successful. China in a decade created more than 10 million private
enterprises which dominate services, retailing, and light industrial production. The Russian
government has produced a deep crisis in the private sector.

- In China no collapse in output occurred prior to commencement of rapid growth - as is

claimed is necessary in Russia. Economic growth accelerated rapidly with the start of the
economic reform and living standards doubled since its commencement. China
demonstrably made the type of economic change Russia requires. Consumer production
became the leading sector of the economy, the supply of high quality foodstuffs enormously
increased, the service sector expanded rapidly, small scale enterprise flourished, output and
productivity of labour and investment both soared, and living standards rose rapidly.
However whereas the Russian government proclaimed these goals in theory, it completely
failed to achieve them in practice. The Chinese economic reform created them in the real
world.

This article demonstrates that this contrast is not accidental. Once the specific character of
the Russian, East European and Chinese economies is understood then the same laws of
economics which determined success in China dictate failure in Russia and Eastern Europe.
The mistake of the Russian government is that it fails to understand the specific character of
the Russian economy and applies policies designed for a quite different structure - the
competitive economies of the West. The economies of Russia, Eastern Europe and China
must, instead, be defined as specific "dual economies" constituted by: (i) an almost pure
monopoly sector which operates according to the laws of monopoly economy, (ii) a non-
monopoly sector which, for theoretical purposes, may be considered as operating according
to laws of perfect competition. The specific dynamic of the economy results from the
interaction of the two sectors. Once the character of these dual economies is understood
then their laws, and the policies necessary within them to achieve success, are clearly
defined.

The relative weight of the national and international markets

Before turning to the structure of the Russian economy, however, a preliminary question
must be considered - the relative weight of the international and domestic markets for
Russia. This is necessary not simply because of the difference between exports and imports
and domestic sales, but because the structure of the international and Russian economies
are different. The international economy may be considered as competitive - only a small
percentage of production can merely be supplied by one country. The Russian domestic
market is within a dual economy. If the dominant sector for the Russian economy were its
international connections then the laws of competitive economy would dominate. If the
domestic market is dominant those of dual economy will operate.
The first error of the Russian government is, therefore, that it fails to draw the necessary
conclusions from the fact that the domestic and former Soviet markets are dominant for
Russia. This error is rooted in the concept of the IMF that countries should seek "export
oriented growth" - as exemplified by South Korea. The specific application is that the IMF
suggests that Russia should be inserted into the world economy as a supplier of raw
materials.

This orientation is defined in the figures of the IMF's A Study of the Soviet Economy. The
concluding section of this, 'Assessment of Medium Term Economic Prospects', projects
former Soviet/Russian industrial production declining by a minimum 20 per cent in the first
year of IMF policies. Measures to increase exports of energy and agriculture are proposed -
notably liberalisation of energy prices which would release oil for export, by reducing
Russian demand, while making large parts of Russian industry unviable. Such a combination
entails that the Russian economy would be fundamentally shifted in the direction of
deindustrialisation and raw material export production.

Such a perspective for Russia is an historic dead end. The most clearly established long term
trend in economics is that the price of raw materials fallsrelative to finished products. All
countries which have undergone economic development, including in the last two decades,
have done so through moving out of primarily raw material production into manufacturing.
If Russia were to accept the distortion of its economy in line with the estimates of the IMF it
would become an historical backwater doomed to national decline.

More fundamentally the entire model of export oriented growth, of the South Korean type,
cannot be applied to Russia for quantitative reasons. A country such as South Korea must
necessarily rely on export oriented growth - as the small size of its internal market prevents
it achieving the necessary economies of scale or specialisation on a domestic basis. But the
size of the Russian economy means different comparisons apply. The best estimates put the
size of the former Soviet economy at approximately the size of Japan's - or approximately
half that of the US or European Community (EC). Comparing Russia with these economic
units, exports of goods are 7.1 per cent of US GDP, 9.4 per cent of EC GDP (excluding trade
among members), and 9.8 per cent of Japanese GDP.

The situation of Russia is equivalent to Western economic units of comparable size. On IMF
calculations, Russian trade is 22.3 per cent of GDP. However 12.9 per cent is with the former
USSR and only 9.4 per cent "external" trade. Such a figure, slightly under 10 per cent of GDP,
is in line with comparable economies and therefore would not be expected to increase
greatly. This is reinforced by the fact that the economy of the former USSR was integrated
not simply in terms of a market but in terms of production. In short 90 per cent of the
market for Russia is either domestic or within the economy of the former USSR. It is the
national, not international, market which is decisive.

The Russian dual economy

Turning now to the Russian economy first the dynamic within the monopoly sector of the
dual economy will be considered and then the relation between the monopoly and non-
monopoly sectors.
The difference between the Russian monopoly structure and the structure of a Western
economy is worth repeating. In the former USSR, for example, 87 per cent of the 5,885
products delivered to the State Supply Commission in the machine building industry came
from single sites. Some 30-40 per cent of industrial products came from single producers.
Enterprises with more than 1,250 employees accounted for 85 per cent of industrial
employment. Not only final assembly but components supply is monopolised.
Similar structures exist in Eastern Europe and, historically, in China - in the West enterprises
with more than 1,000 workers account for only 20-33 per cent of employment. Even in an
extremely concentrated and capital intensive sector, such as Japanese semi-conductors, the
top five firms only account for 60 per cent of production. A Japanese automobile plant has
13,000 firms, many small and competing, directly and indirectly supplying it.

The Russian economy in the industrial sphere is closer to a perfect monopoly structure than
anything in the West. Furthermore the hopes of the Russian government that either
privatisation or international competition can offset the effects of this monopoly structure
are illusory as (i) monopolisation is of physical production, not simply ownership, and
therefore privatisation will not change the situation (ii) given Russia's problems with
exports, no amount of imports sufficient to create large scale competition on the domestic
market can be financed.

The laws of operation of monopoly economy are well known -and have been applied by
many Russian economists in pointing out the errors of the government's policies. In the
former economic system monopolies either produced to planning targets and, because of
price controls, could in any case only maximise profits by increasing output. With a
transition to full price liberalisation a monopoly's rational profit maximising market strategy
is to reduce output and increase price. This occurred in Russia and Eastern Europe and by
itself explains a large part of the economic decline.

The dynamic within the credit system

These direct effects of monopolisation on production are reinforced by the dynamic within
the monetary system. As this underlies the dispute over credit policy, and shows the
incoherence of the government's strategy even within its own monetarist framework, it will
be considered from a fundamental point of view.
The analytical starting point of monetarism is the Quantity Theory of Money. This states that
MV=PT (Mass of money x Velocity of its circulation = Price level x Transactions in the
economy (equivalent for present purposes to output)). This formula is true by definition and
therefore in any economic system. Monetarism, following Friedman, asserts that V is
essentially constant - which will be accepted for present purposes.

The dynamic under monopoly economy is then clear. By algebraic rearrangement the
quantity theory states that T=MV/P - ie, given that velocity is taken as constant, the change
in output depends on the ratio between the change in the money supply and the change in
the price level.

The consequence of the vast upward movement in prices under a price liberalised monopoly
economy is then evident. Unless the money supply rises by at least at an equivalent rate to
the price level (a 350 per cent increase in January alone) output must decline. The attempt
to constrain the money supply under monopoly pricing necessarily produces a fall in output.
In Eastern Europe this mechanism operated violently. The quarterly rate of expansion of the
Polish broad money supply fell from 190 per cent in the third quarter of 1989 to under 10
per cent in the second quarter of 1990 in the context of a 400 per cent increase in domestic
prices. Real money supply, the ratio of money to the total price of output, fell by 44 per
cent. As the money supply did not accommodate the increase in prices output collapsed.

The joint demand by Russian industrialists and trade unions this summer to expand credit,
to avert a catastrophe, was therefore justified not merely from a contingent but from a
fundamental theoretical point of view - as are measures such as indexation of capital assets.

The problem, however, is that while expansion of the money supply is necessary under
monopoly to prevent the collapse in output - and its social and output effects can be
ameliorated by measures such as indexation of wages, pensions, and amortisation - it
cannot halt the price increases. This problem will be returned to below.

The relations between the monopoly and non monopoly sector

If the dynamic created within the monopoly sector is for output to decline and prices to
increase then the relation of the monopoly to the non-monopoly sector is equally clear.
Under full price liberalisation monopoly output declines but simultaneously its prices rise
relative to the non-monopoly sector. These two basic laws: (i) Within the monopoly sector
decline in output and increase in prices; (ii) the rise of monopoly prices relative to non-
monopoly prices, together define the basic dynamic of the dual economy.

The 'scissors crisis' between agricultural and industrial prices, the fact that throughout
Eastern Europe the agricultural crisis is even deeper than the industrial crisis, is one
manifestation of this. Although food prices rise rapidly the price of industrial inputs into
agriculture, from the monopoly sector, increase even more quickly - a process described by
agriculture minister Khlystun. Crushed between a decline of demand on one side, due to
impoverishment of the population, and a rise in input prices on the other, the agricultural
sector is thrown into profound crisis.

However the same process, with specific modifications, operates in relation to other non-
monopoly sectors. It is for these reasons that full price liberalisation in Russia has produced
a deep crisis within the small private business sector - Professor Yasin has pointed out that
50 per cent of cooperatives in Russia have gone bankrupt. This dynamic is strategically
decisive not only in itself but, in particular, because the relation between the monopoly and
non-monopoly sectors is inseparably connected to the single most important historical
distortion of the domestic Russian economy - its underdevelopment of individual
consumption. As this issue is at the core of the contrast between economic success in China,
and disaster in Eastern Europe, it will be considered in detail.
The underdevelopment of consumption in Russia

The historical underdevelopment of individual consumption in Russia is clear. Only 55 per

cent of former Soviet GDP was devoted to personal consumption - compared to 60-65 per
cent of GDP in most Western economies and 67 per cent in the United States. This
underdevelopment of consumption was disastrous from the point of view of production -
destroying the incentive to work. However it also profoundly distorted the structure of the
supply side of the economy.

- The most rapidly growing sectors of the post-war world economy, in addition to computers
and related industries, were increasingly concentrated among consumer durables and
services. However, due to the low share of individual consumption in the former Soviet
economy, these sectors had a very restricted market and were inhibited in their
development. The sectors in which the former USSR concentrated - metal production and
machine building - were, in contrast, among the most slowly growing sectors of world
production.[3]

- The low percentage of consumption concentrated production in sectors requiring very high
investment per unit of output (heavy industry, energy) and underdeveloped sectors with
much higher ratios of output to investment (light industry, services). This by itself dictated a
low productivity of capital.[4]

- Investment to meet the needs of the population was extremely low. In the main Western
economies one sector, housing, accounts for approximately 23-33 per cent of total
investment. In Russia, in 1971-89, the average share of housing in investment was only 15.4
per cent. [5]

- Services, the most rapidly growing sector of a modern economy, were underdeveloped.
Employment in services in 1990 was 57 per cent of civilian employment in Germany, 59 per
cent of civilian employment in Japan, and 71 per cent in the US but only 45 per cent in the
USSR.[6] While these are not the only factors explaining the low productivity of capital in
the USSR expansion of Russian production into consumer durables and services would, by
itself, raise the productivity of investment. [7]

The structure of employment and industry

The relation between heavy and consumer industries and services is, however, inseparably
connected to that between the monopoly and non-monopoly sectors of the economy. Light
industry and services are characterised by much smaller units of production than heavy
industry and by a quite different structure of employment. For example in Germany, a
country with a very large industrial sector, 11 per cent of the workforce are self-employed/
employers. However in retailing and wholesaling 18 per cent are self-employed/ employers,
in the private service sector 20 per cent, and in restaurants and hotels 36 per cent - in
agriculture the figure is 79 per cent. Within German manufacturing only 3.9 per cent are
self-employed or employers. But in textiles and clothing 8.5 per cent are self-
employed/employers, in food processing 9.4 per cent, and in miscellaneous (chiefly light)
manufacturing 12.3 per cent. In construction 10 per cent are self-employed/ employers.[8]
In contrast, in 1989, it was estimated that only 0.2 per cent of the workforce were legally
self-employed in the former Soviet Union. A further 3.5 per cent were employed in the
cooperative sector, giving a total of 3.7 per cent - equivalent to less than 3 million persons in
Russia. However production for the consumer sector cannot be developed without creating
a very large number of small enterprises - ie a huge development of the non-monopoly
sector. Taking international comparisons, between 8 and 19 million self-employed/ small
employers must be created in Russia - the higher figure being necessary if the decision were
taken to de-collectivise agriculture. However in Russia, under the economic policies of the
government, the shift in relative prices in favour of the monopoly sector crushes the non-
monopoly sector - making it, among other things, impossible to meet consumer demand.

The basic dynamic of the dual economy under price liberalisation

The basic mechanism of the dual economy under conditions of full price and economic
liberalisation, that is the East European and Russian economic reform, may now be seen: (i)
output in the monopoly sector declines while its prices rise (ii) the rise in monopoly prices
relative to non-monopoly prices crushes the non-monopoly sector - creating a mechanism
sucking resources out of the non-monopoly sector. What is instead required is the exact
opposite mechanism. One which (i) maintains output in the monopoly sector (ii) pours
resources into development of the non-monopoly/consumer sector. The Chinese economic
reform precisely created such a mechanism. In examining this first the monopoly sector will
be considered and then, most important, its relations with the non-monopoly sector.

The Chinese economic reform

No significant part of the Chinese monopoly industrial structure was privatised . There were
several waves of 'small privatisation', in particular in retailing, but these did not affect large
scale industry. Output in the monopoly sector was expanded by three complementary
mechanisms.

- the entire economy was expanded extremely fast under the impact of policies discussed
below. Demand for goods from state industry was therefore high.

- slightly under half investment in the state sector was subject to a central plan - such
investment declined only from 8.7 per cent of GNP in 1978 to 7.5 per cent in 1988. Large
supplies of credit were given to enterprises under a "credit plan" - such credits increased
from 9.3 per cent of GNP in 1978 to 29.9 per cent of GNP in 1988. However, because price
controls in the monopoly sector existed, enterprises could only maximise profits by
increasing output.

This combination of high demand and cheap investment credits led to extremely rapid
increases in state output. Gross output by state industry in 1981-86 rose by 56 per cent - an
annual growth rate of 8.9 per cent. The change in industrial structure in China, therefore,
came not because the state sector was curtailed or privatised, as in Russia, but because the
non-state sector grew even more rapidly - gross industrial output in the non-state collective
sector, a concept discussed below, increased at 19.3 per cent a year in 1981-86.
Similarly Chinese investment rose not because the share of state investment fell - despite a
reduction in 1979-81 it was 19.5 per cent of GNP in 1988 compared to 19.2 per cent of GNP
in 1978 - but because non-state investment rose from 7.6 per cent of GNP in 1978 to 10.2
per cent of GNP in 1989.

China therefore grew not by destroying its state sector but by altering the relations between
the monopoly and non-monopoly sectors - rapidly expanding the latter. This mechanism is
the key to the Chinese economic reform. First the demand and then the supply sides of the
process will be considered.

The demand side of the Chinese economic reform

On the demand side the foundation of the Chinese economic reform was a radical increase
in the share of personal consumption in the economy . In only three years, 1978- 81, the
share of private consumption in GNP was raised from 52.6 per cent to 58.5 per cent - an
increase of almost 6 per cent. In real terms individual consumption rose by 20 per cent. All
other priorities were subordinated to achieving this initial leap in consumption [9] -
government final consumption was reduced from 14.2 to 11.5 per cent of GNP and fixed
investment was temporarily reduced from 26.8 to 20.1 per cent of GNP (although fixed
investment recovered rapidly once the initial transition to a new pattern of demand had
been achieved).

This huge, six per cent of GNP, upward shift in the share of personal consumption was the
precondition for the transformation of the supply side. New industries - high quality foods,
consumer durables, and services - could only develop if a market was created for them. The
rapid upward shift in consumption was the mechanism to achieve this. The time sequence
of the shift is clear. There was no voluntaristic attempt, as in Russia, , to lower military
spending with reckless speed.

Over the 10 years 1978-88 reduction of the share of military expenditure in GNP was the
chief means by which the increase in the share of personal consumption in GNP was
financed. Military expenditure as a percentage of GNP was reduced by slightly over half in
constant price terms over a decade - the 3.1 per cent of GNP fall in the share of military
spending, in current price terms, almost exactly matched the 3.8 per cent of GNP rise of the
share of personal consumption. But the reduction of the share of military expenditure was
gradual, 0.3 per cent of GNP a year in current prices terms. In 1979, with transitional
expenditures, the percentage actually increased marginally.[10]

The increase in the share of personal consumption was initially financed by a reduction in
the proportion of fixed investment in GNP - a 6.7 per cent fall in the percentage of fixed
investment in GNP in 1978-81 financed a 5.9 per cent of GNP increase in the share of
personal consumption. After 1981, however, the benefits of reduced military spending
began to be felt, and the enormous increase in the share of personal consumption
necessary to bring about the initial change in economic structure could be reduced. By 1984
the percentage of fixed investment in GNP had regained its 1978 level. The dynamic of the
change on the demand side over the decade is therefore clear. Initially the proportion of
consumption was raised by reducing fixed investment. Then, as military spending fell, the
resources released were shifted into investment. [12]

The supply side

This huge shift in the structure of demand was connected to the supply side of the economy
by being used to produce a large shift in relative prices in favour of the non-monopoly
sector. This mechanism was the key to the economic reform.

The sequence of the price shifts is clear. In 1978-81, with the start of the rural reform, the
procurement price of agricultural goods was raised by 38 per cent more than industrial
goods and the price of consumer goods rose 11 per cent faster than those in the economy
as a whole. In 1984-86, with the start of the urban reform, consumer prices rose by a further
11 per cent compared to average prices. The population was protected against the rise in
prices because the resources saved through reducing investment were transferred into
consumer subsidies and increasing wages. [13] Therefore, unlike Russia, as the population
did not suffer from the change in relative prices, and benefitted greatly from the increase in
supply, there was popular support for the changes, not opposition.

Over the decade as a whole consumer prices rose by 24.8 per cent relative to average prices
and agricultural prices 77 per cent relative to industrial prices. [14]

The shift in favour of non-monopoly sectors

As the boundary between consumer and investment goods also largely corresponds to that
between the monopoly and non-monopoly sectors of the economy, what fundamentally
took place in China was clear. A gigantic shift was produced in favour of prices in the non-
monopoly sector – i.e. the exact opposite to that in Eastern Europe.

The contrast, in the crucial sector of agriculture, is shown in Figures 3 and 4 [The original
draft article graphed the figures given below- JR]. Figure 3 illustrates the upward shift in
consumer prices and agricultural prices in China. Figure 4 shows the movement of relative
agricultural prices in Czechoslovakia following price liberalisation - similar figures exist for all
East European countries.[15] In three months following Czech price liberalisation
agricultural prices rose more rapidly than the general price level - due to pent up demand
for food . However, in the following nine months, relative agricultural prices then fell
rapidly, until by a year after price liberalisation they were 8 per cent lower than before it.

The contrast to China is evident. In China relative prices were moved sharply in favour of the
non-monopoly/ agricultural economy. As all barriers were removed to production for
consumer and agricultural markets, and as small scale production can develop rapidly in
response to demand, consumer and agricultural production boomed. By the price shift the
Chinese government produced not merely a legal but real economic possibilities to develop
consumer/small scale production - whereas in Eastern Europe a legal right to establish
enterprises is created but they are crippled in practice by the decline in consumer demand
and the effect of monopoly pricing.
If, in a dual economy full liberalisation of prices becomes a mechanism whereby the
monopoly sector sucks resources out of the nonmonopoly sector, China created a
mechanism whereby huge resources were pumped into the non-monopoly sector to meet
consumer demand. Once the shift in prices, and relative demand, was coupled with
liberalisation in supply the other processes flowed logically.

In China three sectors were developed:

- state, 'collective' (frequently groups leasing premises from municipalities, but also
cooperatives with their own facilities etc), and private.[16] The industrial private sector
remained small - in 1989 56 per cent of industrial production was by the state sector, 36 per
cent by the collective sector, and 5 per cent by the private sector . However the collective
sector grew more rapidly than the state sector - increasing its share of industrial output
from 20.7 per cent in 1980 to 35.8 per cent in 1989. [17]

In the service sector, by 1988, only 39 per cent of retailing turnover was in the state sector,
compared to 33 per cent in the collective sector, and 19 per cent in the private sector. In
catering 22 per cent of turnover was state sector, 25 per cent collective, and 50 per cent
private.

Service employment exploded. In 1978-88 China's total workforce increased by 35 per cent
[18] but catering employment increased by 327 per cent, retailing by 380 per cent, and
other services by 750 per cent.[19] Total employment in these three sectors increased from
6 million to 30 million.

In agriculture decollectivisation was undertaken - land remaining nationalised but

responsibility for production passing to family farms. From the production point of view a
system of essentially perfect competition was created.

Onto this a system of incentives was grafted by the state paying a fixed price for a quota,
and above that guaranteeing to buy all agricultural production at a higher price. [20] To
produce incentives agricultural procurement prices were progressively raised. [21]

The increase in agricultural output followed the predictions of economic theory. Between
1980 and 1984 food output in China increased by 6.9 per cent a year - cereals by 7.4 per
cent a year. By 1984 the fundamental problem of food supply was solved, the relative
increase in procurement prices was halted, and attention was switched to increasing output
of high quality food (beef, pork, oranges, bananas, sugar) and industrial crops.

The interaction between rural and urban sectors created a huge demand for consumer
goods. Total industrial output in 1979-84 rose by 8.6 per cent a year but production of
televisions by 47 per cent a year and refrigerators by 98 per cent a year. After 1984, with a
halt to the rise of procurement prices, agricultural growth slowed to 5.0 per cent a year but
the annual increase in industrial output rose to 14.5 per cent a year. [22] Production of
consumer durables was now large in absolute terms - in 1988 China produced 7.6 million
refrigerators and 25 million television sets. A housing boom took place.[23]
By this mechanism China made the type of structural transformation required by Russia.
With monopoly output increasing due to state control, and resources pouring into the non-
monopoly sector due to the shift in relative prices, consumer production of all sorts soared.

This mechanism in China was, literally, the exact reverse of that in Eastern Europe and
Russia. In Eastern Europe, state domination of the monopoly sector was abandoned,
monopoly output collapsed while the monopoly sector simultaneously sucked resources out
of the non-monopoly sector through the rise in relative prices. In China state domination of
the monopoly sector meant: (i) its output was raised, (ii) the price boundary between the
monopoly and non-monopoly sector could be manipulated to pump resources into the non-
monopoly sector. Success in China flowed just as inevitably from application of the
economic laws of the dual economy as did disaster in Eastern Europe.

The Chinese economic reform, therefore, was not simply about the relations between
industry and agriculture. It concerned the general relations between the monopoly and non-
monopoly economy - of which the agricultural-industrial relation is only one, extremely
important, aspect. While in a predominantly rural country, such as China, agricultural prices
were raised even more rapidly than those for all consumer goods such shifts in relative
pricing can, in principle, be used equally in favour of other non-monopoly sectors.

From a fundamental economic point of view, indeed, there is a rather interesting parallel
between the Stalin system and the system of East European reform. Stalin produced a huge
shift in relative prices against agriculture and reduced consumption. So, by a different
mechanism, does the East European reform. In its most fundamental feature the Chinese
economic reform is the exact opposite to both. Furthermore it is clear from the laws of the
dual economy that only the fundamental principles of an economic reform of the Chinese
type can succeed in Russia. No matter how long an 'East European' reform is applied it can,
for reasons the outlined, only lead to disaster.

Equally a reform simply of the Ryzhkov [former Soviet prime minister – JR] type cannot
create the necessary huge network of non-monopoly enterprises necessary to meet
consumer demand and achieve flexibility in production - no administrative mechanism,
centred for example on conversion of defence industries, can create this. Instead, in China, a
system was created whereby state investment led the economy through market
mechanisms not administrative decisions - the only possible way with decentralised
consumer production.

What are the implications for the Russian economy? Russian suffers from the great
disadvantage that, unlike China it does not start from a stable, if stagnant, base but from a
catastrophic decline in output created by an East European economic reform. Therefore, an
intermediate term programme for structural transformation must be integrated with an
immediate anti-crisis package. However the broad principles are clear.

(i) The precondition for success is to end the destruction of the state industrial sector.
Without this (a) output in the monopoly sector cannot be stabilised (b) price relations with
the non-monopoly sector cannot be controlled.
(ii) It is imperative to restore the national market. Everything possible must be done to re-
strengthen links between the republics - it is this market, not the external one, which is
decisive. As a supplement any recreation of trade links with Eastern Europe will be mutually
beneficial.

(iii) Domestically, in the short term, everything must be subordinated to halting the decline
in living standards and consumption. This is not merely necessary for human reasons but to
provide the basis of structural transformation of the economy. Given that consumer output
has fallen less rapidly than total output the share of consumption in GDP has already
increased (unfortunately in a declining, not expanding, economy). Both an immediate
stabilisation programme, and structural transformation, require the introduction of wage
indexation. Immediately wages must be indexed to prices, to halt the decline in
consumption and the domestic market.

Later they should be indexed to ensure a share of individual consumption in GDP of

approximately 60 per cent (5 per cent higher than the historic level ).

(iv) To halt inflation, and create conditions for the necessary rise in relative prices of
consumer goods and agricultural items, price controls must be reintroduced in the
monopoly sector. In some non-monopoly sectors in which competition has been developed
this may not be necessary. In competitive consumer sectors prices may be allowed to rise,
within limits, relative to monopoly prices (the population will be protected against the
effects of this through wage indexation).

(v) To create supply to respond to demand shifts an extremely rapid programme of

elimination of state control and/or ownership in areas where competition can be created
quickly should be undertaken - "small privatisation" must be as rapid as possible.

(vi) Output in the state sector must be maintained through a system of state orders, state
contracts etc. Large credits for enterprises must be given and their assets must be indexed.

(vii) In China, where the economy was stable, investment was initially reduced to create
resources for extra consumption. However in Russia a precipitate investment collapse is
underway - the share of investment in the economy has almost certainly already declined
too much. The problem is therefore to stabilise and increase investment. This must be done
through: (i) state decisions on investment in priority sectors, (ii) strong incentives for
investment such as indexation of amortisation and tax incentives. Given the current depth
of the crisis strong administrative decisions are almost certainly necessary on investment -
transition to credit as the primary instrument for maintaining investment can only function
when inflation has been curtailed.

(viii) While in the intermediate term the resources to increase the share of individual
consumption in the economy must come from reduction in the share of military expenditure
this cannot be cut precipitately - closure of armaments factories would, in any case, reduce
overall demand in the economy. Use of the resources of the military complex in exports
would, however, be economically rational.
Three groups clearly have an interest in such an economic reform: (i) Industrialists and
managers who wish to stop the destruction of industry and prepare conditions for economic
modernisation; (ii) Representatives of the mass of the working population who are
interested in halting the decline in consumption and production, maintaining employment
and preparing for a rapid expansion of consumer production, (iii) Small business, which
would gain an economic climate in which it would thrive - rather than one in which it is
given a legal right to exist but is crushed by economic processes.

The three interests coincide in the restoration of the domestic Russian economy - that is
such a solution is truly "national" in character. The forms in which these three groups would
work out their interests is, of course, a question of politics and domestic Russian affairs
which it is not within the competence of this article to discuss.

Naturally Russian economists will be able to develop much more detailed and adequate
programmes than these - which relate only to the most fundamental issues. However the
economic laws of dual economy, which dictated success in China and failure in Eastern
Europe, are not specific but universal in character. They therefore apply to Russia. The
specific application of these laws in defining an adequate programme for Russia can, of
course, only be achieved in Russia, by Russians.

* * *

This article was written in April 1992 and originally appeared in Russian in Voprosy
Ekonomiky in September 1992. The new introduction appeared on the blog Key Trends in
Globalisation on 31 December 2008.

Notes

[1] Set out in the Memorandum to the IMF and 'The Programme of Deepening of the Economic Reform'.

[2] Both in terms of domestic production and international competitiveness.

[3] This trend was already clear in 1960 to 1973. In this period world output of, for example, iron and steel rose only by 5.8 per
cent a year, non-ferrous metallurgy by 5.6 per cent a year, and metal piping by 4.4 per cent a year - compared to annual rates of
increase of 13.4 per cent for computers, 11.6 per cent for photographic equipment, 9.6 per cent for watches and clocks, 9.0 per
cent for pharmaceuticals, 8.4 per cent for consumer electronics, and 8.2 per cent for household goods (refrigerators, washing
machines etc).

But after 1973 the development became even more extreme. After 1973 18 of the 25 most rapidly growing branches of industrial
output were in only 3 groups: electronic and computer equipment (computers, electrical components, telecommunications, and
electrical equipment), high quality consumer products (pharmaceuticals, toiletries, consumer electronics, photographic and
optical equipment, watches and clocks, household goods, books and printing, and paper), and food products (animal fodder,
edible fats, meat and fish, meat preserves, cereal based products, and beverages). The world market in sectors in which the USSR
specialised - such as iron and steel, piping, machine tools, and non-ferrous metallurgy - actually shrank ie the USSR was producing
into declining sectors. By 1987 the USSR produced more than twice as much steel as the United States, twice as much cement and
almost three times as much iron ore but was totally underrepresented not only in computers and electronics but in the most
dynamic sectors of consumer durable and high quality food production.

[4] To take international comparisons, in Germany, from 1980 to 1988, the ratio of annual value added in manufacturing to gross
fixed capital formation in manufacturing was 850 per cent. However it was only 650 per cent in basic metals, 690 per cent in non-
metallic minerals, 840 per cent in fabricated metal and machine production. In light, primarily consumer, manufacturing the
output to investment ratios are far higher - in Germany 980 per cent in food processing, 1210 per cent in furniture production,
and 1230 per cent in clothing. In the service sector ratios are similar to light industry - 930 per cent for restaurants and hotels,
1030 per cent for wholesaling and retailing, and 1390 per cent in financial services. In energy, in which the USSR specialised, the
ratio of output to investment is even lower. A comparison cannot be made with Germany, where production is insignificant, but
for the US and UK, Western economies with large energy sectors, the ratios in the 1980s were 350 per cent for the United States
and 540 per cent (including coal production) for Britain.

[5] The share of housing in the reproducible assets of the USSR is less than 18 per cent compared to 30 per cent in the US, 33 per
cent in west Germany, and 45 per cent in France.

[6] In "personal" (consumer) services in particular services employment in the USSR was only 19 per cent of the working
population compared to 28 per cent in Germany, 33 per cent in France, 37 per cent in Japan and 39 per cent in the US. The
disastrous situation of the Soviet retail system is easily explained by the fact that only 6 per cent of the working population was
employed in wholesaling and retailing compared to 15 per cent in Germany, 17 per cent in France, 22 per cent in the US, and 23
per cent in Japan. West Germany, for example, itself a Western country with an unusually large heavy industrial sector, devoted
25.2 per cent of its investment to industry and 24.4 per cent to services, while the USSR devoted 36.4 per cent to industry and
only 14.9 per cent to services.

[7] In addition to domestic effects the inappropriate structure of industrial production struck at the international competitiveness
of the Soviet economy. This is graphically illustrated by comparison with the most rapidly growing economies in the last two
decades apart from China - the Newly Industrialising Economies (NICs) of South Korea, Taiwan, Hong Kong, and Singapore. Starting
from far lower levels of development than the USSR these were able to achieve spectacular export success by concentrating on
sectors such as consumer electronics. They were aided by technological mastery in consumer goods being much easier to achieve
than in the investment sector - UN studies indicate that in washing machines, refrigerators, radios, and televisions South Korea
and Taiwan are already at the same technological level as Japan, that is the most advanced in the world. These economies
dominate the export of cheap personal computers. However the USSR, which had the advantage of a much more advanced
starting point and a much larger domestic market, failed to develop any such industries - in part because its domestic production
of consumer items was extremely low compared to the size of its economy.

[8] The proportion of the working population who are self-employed/employers in countries with larger agricultural sectors than
Germany is much higher - 15 per cent in France, 21 per cent in Japan, 27 per cent in Spain, and 32 per cent in Italy. Even in the
United States, which has the most developed economic structure, the figure is 9 per cent.

[9] Far from allowing consumption to collapse, as in Russia and Eastern Europe, China started its reforms by determined measures
to raise the short term living standards of its population.

[10] As the economy more than doubled in size in the decade real military expenditure probably rose slightly at the same time as
its share in GNP was halved.

[11] After 1984 the percentage of fixed investment rose above its pre-1979 level, financed by further reductions in military
spending and reductions in other government economic expenditure, until by 1989 economic overheating was occurring The
percentage of fixed investment in the economy was then reduced to its 1984 level.

[12] Such figures also show clearly that far from the state sector abandoning the process of change to the market it in fact led the
transformation through state control of the investment mechanism. First there was marked reduction of the share of state fixed
investment in GNP in 1978-81, from 19.2 per cent of GNP to 14.4 per cent, to create the space for increased consumption. Then
through the reexpansion of state investment as a percentage of GNP in 1981-86, from 14.4 per cent of GNP to 20.9 per cent of
GNP, general investment was expanded. Finally in 1988- 89 state investment was reduced to curb economic overheating (Figure
3). The difference to the previous situation was that state investment increasingly led the economy through the market, not
through administrative decisions - which in any case could not have been implemented given the enormous increase in the
number of small enterprises discussed below.

[13] In the first phase, from 1978 to 1981, subsides on daily necessities rose from 2.2 per cent of GNP in 1978 to 6.4 per cent of
GNP in 1981 - an increase in subsidies of 4.2 per cent of GNP. Later consumer subsides were reduced and instead compensation
was given through de facto indexation of increased wages and pensions - a more efficient system but which has exactly the same
result.

[14] If relative prices had remained as in 1978 the share of private consumption in GNP in from 1978 to 1988 would actually have
contracted from 52,6 per cent to 45.2 per cent - instead of expanding from 52.6 per cent to 56.4 per cent.

[15] In Hungary food prices rose by 10 per cent more rapidly than the general price level in the three months following price
liberalisation at the end of 1989. Food prices then fell by 16 per cent relative to the general price level - leaving them six per cent
lower, in relation to prices, than before price liberalisation. In Poland the process is not yet finished but the trend is clear. Food
prices rose by 30 per cent relative to other prices in 1989-90. They then fell by 20 per cent relative to other prices and are
continuing to fall rapidly.
[16] The second category undoubtedly contains a proportion of both quasi-state and quasi-private enterprises as well as genuine
collective ones.

[17] This rapid development of the "collective" industrial sector in China explains the extremely rapid development of small
industrial enterprises in China - by 1986 there were 500,000 industrial enterprises in China of which 420,000 were small scale
(Jiang Yiwei, "Enterprise reform" in The Chinese Economy and its Future ed Peter Nolan and Dong Fureng, Polity Press Cambridge
1990 p159.). This sector primarily developed in light industry, which also helped its extremely efficient use of capital - by 1987 one
third of industrial output was produced by small enterprises with only one eighth of investment. This sector also developed
significant exports - $5 billion in 1987.

Overall the share of light industry in total industrial output increased from 42.7 per cent in 1978 to 49.3 per cent in 1988. Three
directly consumer industries - food processing, textiles and clothing, and publishing and paper making - alone increased their
percentage of industrial production from 29.7 per cent in 1978 to 34.3 per cent in 1987 on the basis of only 17.8 per cent of
industrial investment - implying an efficiency in investment almost double that of industry as a whole.

[18] Industrial employment increased by 59 per cent. Employment in construction, reflecting

the building boom, increased by 178 per cent.

[19] By 1989 only 17 per cent of employment in retailing was in the state sector, 34 per cent in the collective sector, and 49 per
cent in the private sector. In catering 13 per cent worked in the state sector, 25 per cent in the collective sector, and 61 per cent in
the private sector. In the other service sectors 19 per cent worked for the state, 31 per cent in the collective sector, and 48 per
cent in the private sector. In the retailing, catering, and service sectors alone more than 10 million new firms were created in
1978-88.

[20] This is technically known as a system of "price perversity". Normally prices remain static, or fall, with increases in output. In
this case average price rose as output rose.

[21] Given the conditions of perfect competition monopoly profits could not be made. But the new incentives gave extremely
strong possibilities to increase profit by increasing output.

[22] This being too rapid and creating overheating in the economy by 1989 after which the pace of growth was slowed down.

[23]As indicated by the figures for the ratio between light and heavy industry output in heavy industry grew more slowly -
although after 1984 coal production still increased at 5.4 per cent a year, steel at 6.4 per cent a year, sulphuric acid production at
7.0 per cent a year, and nitrogenous fertilizers at 12.5 per cent a year