I. Introduction
Following the awarding of the 2024 Nobel Prize in Economic Sciences to Professors Daron Acemoglu and Simon Johnson of the Massachusetts Institute of Technology and Professor James Robinson of the University of Chicago, there has been renewed attention paid to the role of institutions in economic development, the subject of their research.
The importance of institutions in economic development is evident when comparing China's planned economy era, characterized by stagnation, with the subsequent reform and opening-up period, which led to rapid economic growth. For a long time, China achieved high growth by leveraging ownership reform and introducing market mechanisms. However, because these reforms were implemented gradually and in the easiest order, the country has struggled to overcome vested interests and ideological resistance that are characteristics of a "transition trap." This is one of the reasons why economic growth has sharply declined in recent years."
For China to overcome the "transition trap" and achieve sustainable economic development, the hypothesis presented by Professors Acemoglu and Robinson in their co-authored book, Why Nations Fail, which postulates that the distinction between "inclusive institutions" and "extractive institutions" is crucial in determining a nation's success or failure, could provide valuable insights. Inclusive systems protect private property rights, uphold the rule of law and a fair market system, and foster innovation and people's participation in the economy. On the other hand, extractive systems allow a small elite to monopolize power and wealth while limiting the rights of ordinary citizens, thus hindering long-term economic development.
Professors Acemoglu and Robinson have assessed China's rapid economic development as a temporary success due to a unique combination of "inclusive economic institutions" and "extractive political institutions." However, they also point out that once a country reaches a stage of development where it needs to go beyond the mobilization of production factors and instead requires innovation, the extractive nature of the political system becomes an obstacle to economic development. They argue that for the Chinese economy to achieve sustainable development, it is necessary to transition from an "extractive political system" to an "inclusive political system" through democratization and the establishment of the rule of law.
II. The failure of the planned economy vs. the success of reform and opening up
The importance of institutions in economic development becomes clear when we compare China's economic stagnation during the planned economy period (from 1949 to the late 1970s) with that of the reform and opening up period (since the late 1970s), when the country experienced rapid development (Note 1).
Professor Zhang Weiying of Peking University postulates that the decisive factor in determining the success or failure of China's planned economy period and reform and opening-up period lies in the changes in the behavior of economic entities brought about by ownership reform and the introduction of market mechanisms (Note 2).
Under China's planned economy system, all economic activity was carried out based on plans by the central government. Companies were not able to independently decide production volumes or prices, and were unable to respond flexibly to market demand. Because all enterprises were state-owned, managers and employees had no incentive to improve efficiency. As a result, problems such as serious shortages of supplies, declines in quality, and stagnation of technological innovation arose.
In the late 1970s, the introduction of the reform and opening up policy marked a major turning point for the Chinese economy. First, the dissolution of people's communes in rural areas and the introduction of the production contract system dramatically increased farmers' motivation to produce. In urban areas, reform of state-owned enterprises gradually expanded management autonomy. In addition, the establishment of private enterprises was permitted, allowing new economic entities to enter the market, resulting in increased competition.
The transition to a market economy has unleashed individual creativity and an entrepreneurial spirit. The pursuit of profit became legitimized, encouraging more people to take risks and venture into new businesses. In special economic zones along the coast, the establishment of joint ventures with foreign firms was permitted, leading to the introduction of advanced technology and management know-how. The activities of these entrepreneurs became a key factor driving the rapid growth of the Chinese economy.
Professor Zhang Weiying emphasizes that institutional reform was the most important thing in China's economic development. The introduction of market mechanisms has enabled prices to reflect supply and demand, enabling the efficient allocation of resources. Furthermore, ownership reform has enabled economic agents to act more efficiently in their own interests. The introduction of competitive principles has promoted technological innovation and service improvements among companies. However, ownership reform and market reform in China are still in progress, and further reforms are needed, such as correcting the dominant position of state-owned enterprises, curbing excessive government intervention in the market, and improving financial markets.
III. The limitations of incremental reform
In the process of transitioning from a planned economy to a market economy, China has not adopted the "radical reforms" known as the "big bang approach" or "shock therapy" promoted by the International Monetary Fund (IMF) and other Washington D.C.-based international organizations, but has instead adopted an "incremental approach," proceeding in the order of least resistance and taking the easiest steps. This strategy was successful, and in contrast to Russia and Eastern European countries that adopted the former approach in the 1990s but suffered economic crises, China maintained social stability while achieving positive economic performance, including a long period of high growth. However, as the reforms progressed, the remaining challenges increased in difficulty, revealing the limitations of the incremental reform approach.
First, the slow progress of reforms has allowed the mindset established under the planned economy to persist, while ideological resistance has hindered deeper reforms. For example, although the inefficiency of state-owned enterprises has been recognized for some time, privatization is still regarded as taboo.
In addition, the incremental approach seeks to avoid conflict among different interest groups by focusing on adjustments in less controversial areas rather than pursuing comprehensive reforms. As a result, reforms often require readjustment. However, new vested interest groups that emerge from recent measures can take root and subsequently resist further reforms.
Furthermore, the government retains significant power in terms of regulations and permits, creating opportunities for bureaucrats to abuse their authority for personal gain, which perpetuates corruption. In this environment, private enterprises face disadvantages in competing with state-owned enterprises, making it difficult to establish a fair market order.
Finally, by prioritizing reforms that are less contentious and easier to implement, more challenging issues remain unresolved. Politicians and bureaucrats often advance reforms that reinforce their privileges and positions, neglecting the interests of ordinary people. In fact, many reforms related to the privatization of large state-owned enterprises and income redistribution have stalled due to resistance from vested interest groups.
IV. Proposal of the "transition trap" hypothesis
In light of this situation in China, the Institute of Social Progress at the Kaifeng Institute of Development Studies at Tsinghua University and the Social Development Research Group in the Department of Sociology at Tsinghua University (hereinafter referred to as the "Tsinghua University Research Group") put forward the hypothesis in 2012, just before the Xi Jinping administration came to power, that the Chinese economy was falling into a "transition trap." The "transition trap" referred to here is the attempt by vested interest groups, such as state-owned enterprises, created in the process of transitioning from a planned economy to a market economy, to block further reforms and to entrench the "hybrid system" of the transition period, resulting in distorted economic and social development and the worsening of problems such as widening disparities and environmental destruction (Note 3).
Based on this recognition, the Tsinghua University Research Group suggested the following measures to remedy the situation.
First, China must join the mainstream of global civilization, which is based on universal values such as a market economy, democracy, and the rule of law. Rejecting the mainstream values of global civilization has been a main cause of why China fell into the "transition trap," and at the same time, it serves as a pretext for maintaining its current structure of interests.
In addition, decision-making regarding reforms should shift from the current system—where implementation is delegated to local governments and departments—to a 'grand design' crafted by the top leadership of the Communist Party and the government. To promote these reforms, public support should be secured by considering feedback from citizens and ensuring that the reforms are based on fairness and justice.
Furthermore, political reform must be accelerated. Corruption greatly weakens the government's authority and ability to implement policies. Political reform must begin with the establishment of mechanisms to constrain power, such as increasing government transparency.
V. Market reforms stalled
More than 10 years have passed since the "transition trap" hypothesis was proposed, and developments in the Chinese economy during that time have largely confirmed it.
The Xi Jinping administration, which came to power following the 18th National Congress of the Communist Party of China in November 2012, was initially seen as being proactive not only in economic reform but also in systemic reform in general. In particular, the "Decision of the Central Committee of the Communist Party of China on Some Major Issues Concerning Comprehensively Deepening Reform" (hereinafter referred to as the "Decision"), which was discussed and adopted at the Third Plenary Session of the 18th Central Committee of the Communist Party of China (Third Plenum) held in November 2013, set "improving and developing the socialist system with Chinese characteristics and promoting the modernization of the country's governance system and governing capabilities" as the overarching goal for comprehensively deepening reform. To that end, the "Central Leading Group for Comprehensively Deepening Reform" was established, with General Secretary Xi Jinping himself as the head. The Decision also clearly stated that "the market will play a decisive role in resource allocation," and emphasized the need to build China into a state under the rule of law. The government also tried to win the support of the people by focusing on eradicating corruption.
In retrospect, however, market reforms under the Xi Jinping administration have largely stagnated. In particular, the reform of state-owned enterprises, which focused on "promoting a mixed-ownership economy," "establishing a modern corporate system," and "improving the supervision and management system for state-owned assets," has inadvertently strengthened the monopoly power of these enterprises and increased government interference in their management. In addition, the business environment for private companies has rapidly deteriorated due to the authorities' tightening of regulations. As a result, the trend of "the state advancing and the private sector retreating" (an increase in the share of state-owned enterprises and a decrease in the share of private enterprises) has become more and more apparent. Factors such as the collapse of the housing bubble, a decrease in the labor force, and the U.S. decoupling policy have further contributed to a significant decline in China's economic growth rate, making the scenario of China's GDP surpassing that of the United States to become the largest in the world less likely in the near future.
Regarding the reason why market reforms are not progressing as expected, Wei Jianing and Wang Yingying of the Development Research Center of the State Council point out the following (Note 4):
First, free debate is restricted in the policy-making process, which hinders the progress of reform. When relevant departments under the State Council formulate reform plans independently, they lack broad input and third-party evaluation, and so tend to prioritize their own departmental interests, making it difficult to maximize the interests of the public and the country.
Second, there is a lack of coordination between the central government and local governments. Excessive central regulation, as seen in free trade zones, for example, hinders local independent reforms and is a key reason why effective reforms have stalled. Furthermore, despite the central government's anti-corruption efforts, frequent instances of misconduct by local governments undermine its authority.
Moreover, the reform plan is overly broad and lacks a clear focus on achieving concrete results. In addition, the absence of defined beneficiary groups for specific reforms diminishes the motivation to advance these changes and may invite resistance from vested interests.
Finally, because personnel evaluations are not tied to reform outcomes, the awareness and capabilities of talented officials are not fully utilized. The lack of incentive mechanisms also reduces motivation to pursue reform.
These factors interact and together hinder the progress of market reforms.
Ⅵ. The need for a shift from "extractive institutions" to "inclusive institutions"
To overcome the "transition trap" and achieve sustainable economic development, China can glean valuable insights from the hypothesis presented by Professors Acemoglu and Robinson in their co-authored book, Why Nations Fail (Note 5).
They argue that the most important factor determining a nation's success or failure is "institutions," and the difference between "inclusive institutions" and "extractive institutions" is the key to determining whether a nation will succeed or fail. Inclusive institutions protect private property rights, uphold the rule of law, and establish a fair market system. Such institutions encourage innovation and new entries, providing more people with the opportunity to participate in economic activity. On the other hand, extractive institutions allow a small elite to monopolize power and wealth while restricting the rights of ordinary citizens. The result is stifled innovation and limited economic opportunity, both of which inhibit long-term economic progress. They argue that these institutional differences explain the economic disparities between modern nations. Notably, most countries that have reached advanced levels of development have adopted inclusive institutions.
Institutions, once established, tend to persist due to strong path dependency shaped by historical events and decisions, significantly influencing the formation of subsequent institutions. For example, in many countries, colonial governance models continue to influence modern institutions. Furthermore, key decisions made at important historical turning points often greatly influence the future trajectory of the system.
Professors Acemoglu and Robinson reject the importance of geographical and cultural factors that have traditionally been pointed out, arguing that climate, the presence or absence of natural resources, and cultural differences are not the most decisive factors in a nation's development. Rather, they argue that the structure of institutions determines how these factors are utilized.
Their analysis implies that inclusive political and economic institutions are essential for sustainable economic development. Democracy and market economies are mutually reinforcing, allowing for broader participation in political and economic realms. Transitioning from extractive to inclusive institutions is challenging as vested interests resist changes that threaten their positions, but it can be achieved through active political participation and social movements.
Professors Acemoglu and Robinson assess China's rapid economic development since the late 1970s as a temporary success due to a special combination of "inclusive economic institutions" and "extractive political institutions." The reform and opening-up policy promoted economic institutional reforms such as the introduction of a market economy, the protection of private property rights, and opening up to the outside world, which made high economic growth possible. However, at the same time, they warn that there are limits to development under "asymmetric institutions" in which one-party rule persists and extractive institutions with concentrated power and limited political freedom remain in place. Political constraints prevent true creative destruction and innovation, and weak intellectual property rights protection stifles innovative entrepreneurship. They also point out that once an economy transitions to innovation-driven growth, the extractive nature of the political institutions become an obstacle to economic development.
Based on this recognition, Professors Acemoglu and Robinson advocate specific reforms to achieve sustainable economic development for China moving forward. In terms of political reform, increasing transparency in the political decision-making process, establishing the rule of law, and expanding citizen political participation through democratization are essential. On the economic front, it is necessary to accelerate reform of state-owned enterprises, liberalize financial markets, strengthen intellectual property rights protections, and create a fair competitive environment for private companies.
VII. Democratization and the establishment of the rule of law are keys to the transition to "inclusive political institutions"
As Professors Acemoglu and Robinson point out, democratization and the establishment of the rule of law are key to China's transition to "inclusive political institutions." This transformation is expected to help resolve China’s structural challenges and foster sustainable growth (Note 6).
First, the establishment of a transparent and consistent legal framework based on the rule of law will create a predictable business environment, promoting investment, innovation, and ultimately economic development. A transparent and fair legal system also enhances market efficiency by minimizing rent-seeking behavior and corruption.
Democratization will enhance social stability by allowing the voice of the people to influence policy decisions. The establishment of the rule of law will improve societal equality and effectively address issues such as environmental protection and anti-corruption.
Furthermore, democratization and the establishment of the rule of law are important means for China to improve its credibility and reputation in the international community. This will enable China to strengthen cooperation and trade relations with other countries, and foster more stable diplomatic ties.
In this way, institutional reform centered on democratization and the establishment of the rule of law will provide the foundation for sustainable economic development in China.
The original text in Japanese was posted on December 9, 2024.
