This is an article that I wrote for the Hertie Essay Competition in 2020. It was published by the German newspaper “WirtschaftsWoche” on the 3rd of October 2020. See the German version here.
The Triumph of State Capitalism?
Democracies and authoritarian countries in South East Asia challenge the claim that democracy leads to economic success. We need to understand the complex relationship between democracy and economic performance in terms of institutions, rather than labels of a regime type.
Democracies in the so-called “Western world” have been in distress. Latest the financial crisis in 2007/08 has exemplified that Western-style liberal democracies are not able to deliver promised economic stability and growth. Rather, we observed that volatile financial markets and lack of regulation have led to stagnating wealth and fortunes of many workers in Europe and the US. The rising economic insecurity casts doubt on whether the model of free market capitalism is a successful one after all.
China is often cited as an example for which not democracy, but rather a one-party system has done exceptionally well in terms of economic development. Since 1997, the growth rate of Chinese GDP has never fallen below 7.5% and even reached as high as 14%. Due to the central rule of the Chinese Communist Party, economic decisions can be implemented faster than in any country which employs democratic decision-making. The continued economic growth allowed millions of people to escape poverty, reaching high standards of living within less than one generation.
State-owned Enterprises – A Recipe for Economic Success?
The Chinese economic system is very different from the Western one. As a “market economy with Chinese characteristics” – also called state capitalism – it aims at increasing economic growth, but economic reforms are initiated by the central government. The state plays a decisive role in financial and political control, and in promoting state-owned enterprises (SOEs). These are created to take part in commercial activities on the government’s behalf, take orders directly from the government, which partially or fully owns the enterprise. China hosts 109 corporations listed on the Fortune Global 500, but only 15 of those are privately owned. This goes to show that the Chinese are dominant in employing SOEs to stimulate the economy.
Is such a model better suited to foster economic growth? Some think so: The British newspaper “The Economist” held a voting debate in 2011 about whether China offers a better development model than the West. A majority of the respondents said that the global financial crisis has exposed weaknesses in Western economies, and that China by contrast suffered only a very brief slowdown before surging back into expansion, with double-digit growth rates.
It may seem surprising that SOEs lead to economic success, given that they are created and run at the expense of free competition and private entrepreneurship – elements, which one normally finds in democracies with free market systems. However, even if SOEs typically operate with lower production efficiency, they help to solve other market-based problems. One is that they allow the government to foster capital-intensive and strategic industries like defense, telecom, aviation, and energy. Those are essential for the economy but cannot be created by the private market because it requires large lump-sum investments and infrastructure construction.
Another advantage of SOEs is that they help to maintain social stability, which is crucial for a functioning economy. Rather than just focusing on profitability, SOEs can also perform the task of hiring excess workers and providing retirement benefits. This proves useful especially in times of crises and high unemployment.
Not only China is challenging the Western ideal of liberal democracy and free markets. The “Four Asian Tigers” in South East Asia further show that one does not always need democracy to do well economically. Taiwan, Hong Kong, South Korea and Singapore have industrialized rapidly between the 1960s and 1990s and grew at very high rates, often more than 7% per year. What is striking is that South Korea and Taiwan grew faster in the decades before they became democracies than they have done since then. Singapore, with its highly efficient and technocratic one-party government has also grown faster compared to the other democratic tigers.
It would be too premature to conclude from these examples however, that central or authoritarian rule is what ultimately leads to long-run growth, and that such systems should be preferred to democratic rule. They need to be taken with a pinch of salt: For example, China is the world’s most populous country and started off very poor in the 1980s, which may explain its high and persistent growth rate. If a country is already a developed high-income economy, it would be hard to maintain such high growth levels in the long term.
Instead of focusing too rigidly on regime labels such as “democracy” or “dictatorships”, and how they relate to the economy in general, we might want to take up a more nuanced view and look to the nature of institutions within a particular country. On a minimal definition, any country can count as democracy so long as it has competitive elections. But this would tell us only very little about their inner workings, how decisions are made and under which constraints and conditions. Hence, paying careful attention to institutions is needed.
In their famous book “Why Nations Fail”, economists Daron Acemoglu (MIT) and James A. Robinson (University of Chicago) argue that when it comes to economic prosperity in the long run, it is the ‘inclusiveness’ of a country’s institutions that matters. Institutions are inclusive, when people are enabled to have a political say, when there is rule of law, and incentives are put in place that reward creativity and talent. On the other hand, institutions are ‘extractive’, when they only benefit a small elite, whilst exploiting over others. Such institutions disincentivize entrepreneurs and citizens to invest and innovate. As a consequence, the country’s economy has no chance of expanding and developing. To support the inclusiveness of economic institutions, inclusive political institutions must be put in place as well.
Taking the authors’ argument, we can see that the relationship between democracy and the economy is highly complex and certainly no one-way street. Take as an example the Korean peninsula. North and South Korea were both at very poor economic levels in 1950, thus being at similar ‘starting points’. From the end of the Korean War in 1953 until 1980, both were governed by dictatorships. But by 1980, South Korean per capita income reached $1589, while North Korea’s per capita income only reached about half of that, $768. In the same year, South Korea began democratizing. In this case then, economic growth gave rise to an increased demand for more political liberties.
The surprising fact that two homogenous societies, North and South Korea, have developed so differently can be explained partly through the difference in their institutions. The institutions in dictatorial South Korea were better in terms of constraints on the executive and also encouraged economic openness and innovation – the were thus less ‘extractive’ in Acemoglu and Robinson’s terms. In the end it was the choices made by the Korean dictators, not the emergence of democratic institutions, which determined the economic trajectory of the two countries.
The Korean example goes to show that rigid labels of democracy or non-democracy can be misleading, since two non-democracies can develop in strikingly different ways. The leaders of a non-democratic country can make intelligent policy choices which foster economic development. In a similar vein, Singapore and Hong Kong have also remained open and invested heavily in education and health, which has allowed them to reap significant economic benefits.
Democracy and Inclusiveness
Of course, democratic elements are often closely related to levels of inclusiveness. Democratic leadership is more likely to foster innovation, allow for competitive markets, encourage openness to education and health, and include a wide part of the citizenry. In a pure free market economy, creativity and talent are rewarded and laziness is frowned upon, leading to a meritocratic society.
But democracies can also exhibit seemingly extractive elements: Precisely the element of reward based on merit and performance may lead to large inequalities. Without governmental intervention, a gap between rich and poor may become self-perpetuating and will be hard to eradicate.
Even if democratic leaders have been elected via majority support of the population, other leaders of large corporations have not. CEOs of tech giants like Google, Apple, Microsoft, Amazon and Facebook are not democratically elected by the citizens they influence and so do not enjoy political legitimacy. But they nevertheless make decisions that impact people’s daily lives and indeed outcomes of governmental elections. It is thus a small elite ruling over a large population, which has little power to influence the decision-making process.
The basic point is that we need to unpack labels such as “democracy” and “dictatorships” and look to a country’s institutions. They are what ultimately determines the trajectory of that country’s economy. Though the label “democracy” is often closely related to inclusive institutions which foster growth, but this does not automatically entail that non-democracies cannot yield similar effects, as cases in South-East Asia have shown.
Who will triumph?
The model of state capitalism may not succeed in the long run. Although growth of the Chinese economy is still higher than what some Western leaders could only dream of, it has weakened in recent years. One way of explaining this development is that Chinese growth expansion starting from the 1980s was primarily driven by the loosening of central planning and collectivization, as well as of course the enormous population and market potential. But this effect starts to weaken as more Chinese citizens have reached a higher standard of living. Thus, the question is not whether the Chinese model can provide short-term growth – it clearly was able to – but rather, whether it can also produce sustained long-run growth and prosperity.
If the argument from inclusive and extractive institutions is convincing, we would conclude that it cannot. Inclusive economic institutions that encourage openness, innovation and creativity cannot thrive long-term if they are hindered by extractive political institutions, such as censorship and mass surveillance. Thus, unless China transitions from extractive to more inclusive political institutions, sustaining high growth rates and economic prosperity will prove difficult.
Western liberal economies and democratic systems are flawed in their own ways, but they also bear a lot of potential: Rule of law, deliberation and discussion, a large labor force are all elements of inclusive economic and political institutions. Still, recognizing that competitive elections are not the same as inclusive political institutions (even if they often go hand in hand), allows us to make more nuanced judgements about a country’s potential of economic success in the long-run. Which economic system will triumph in the long run? Let the institutions decide.