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Armchair Economics Defeated: How China Escaped Shock Therapy

If you want to know how China escaped Russia's dismal fate and became the world's industrial powerhouse instead of deindustrializing, read How China Escaped Shock Therapy. My review of Isabella Weber's book on the SASE blog.

 

How should state socialist economies be transformed? This was one of the late 20th century’s most central issues. How, then, did China become the world’s industrial powerhouse while Russia deindustrialized? Isabella Weber’s award-winning book How China Escaped Shock Therapy: The Market Reform Debate (Routledge, 2021) explores the economic policy debates behind China’s developmental success.


The Russian Contrast


Isabella Weber’s How China Escaped Shock Therapy challenges the neoliberal globalist narrative concerning China. Though the gist of the argument is about restructuring the Chinese economy in the 1980s, Weber goes to great lengths to contextualize these reforms by reviewing a host of relevant global examples. The end of the 1970s was a transformative moment around the world. Advanced capitalist countries had been struggling with inflation and sluggish growth, developmentalist regimes in Latin America were sinking ever deeper into debt, and socialist reform attempts in Eastern Europe failed to reinvigorate economic development. A new development paradigm was on the cusp of a breakthrough, promising new economic impetus by retrenching the state. The radical reforms of Pinochet, Reagan, and Thatcher were followed by avant-garde neoliberal experiments in East-Central Europe in the 1990s. These radical neoliberal reform policies were condensed into a blueprint that came to be known as shock therapy: policies of rapid stabilization, liberalization, and privatization.


The conventional wisdom holds that China’s miraculous economic growth following the second half of the 1970s is a direct consequence of economic liberalization and the country’s integration into the global capitalist economy. The heterodox-institutionalist critique of the globalist narrative that Weber also follows does not suggest that global integration is detrimental to socioeconomic development. The argument is rather that the juxtaposition of successful neoliberal globalism and inward-looking statism is utterly misleading. Instead of succumbing to the intellectual fashion of the day, China’s economic policymakers steered away from shock therapy. China followed other East Asian developmental states that integrated into the global economy while maintaining the state’s central role.


To contextualize China’s economic success, Weber starts by contrasting China with Russia and Eastern Europe. Russian leaders also globalized their economy after the collapse of state socialism, but in a markedly different way. Adhering to the blueprint of shock therapy, they liberalized and privatized as quickly as possible. The result was total economic chaos and “suffering of epic proportions,” as Ghodsee and Orenstein show in their recent book. As post-socialist countries rapidly liberalized their economies, the former socialist industry disintegrated and vanished.


Some countries, such as those in East-Central Europe, managed to partially reindustrialize through foreign investment, but lost control over the commanding heights of their economies by transferring state assets to transnational corporations. Now, these purported Central European success stories are also facing developmental bottlenecks that challenge the stability of liberal democracy in the region. Russia deindustrialized and is sustained mainly by its oil and gas reserves. Russia’s share of world GDP almost halved, from 3.7 percent in 1990 to about 2 percent in 2017, while China’s share increased close to sixfold. The hardest-hit post-socialist countries have not recovered their levels of economic development of the late socialist period by the end of the 2010s. In 2016, the real GDP per capita (in 2011 USD) of Ukraine, Moldova, Serbia, Montenegro, Tajikistan, and Georgia was still below the 1989 level.

In parallel to this economic collapse, an unprecedented mortality crisis hit Eastern Europe. The number of excess deaths may have been around seven million in the region in 1991-1999, with five million in Russia alone. In contrast, China enjoyed population growth rates of about ten percent throughout the 1980s and 1990s, and life expectancy has been improving without interruption.


Historical roots of a modern debate


Isabella Weber’s meticulously researched monograph tells the story of China’s fortunate break with the international economic policy mainstream, which allowed the country to escape Russia’s dismal fate. In Weber’s narrative, ideas are central. As she asserts, “China’s deviation from the neoliberal ideal primarily lies not in the size of the Chinese state but in the nature of its economic governance” (p. 3). Crucially, the Chinese debate did not revolve around whether to reform or not, but whether to reform radically or gradually by maintaining the state’s role.


Though the book focuses on the 1980s, Weber sets the scene with a bold move, going back to ancient Chinese debates in the Spring and Autumn and Warring States eras (772-221 BCE). Weber shows that officials of these eras were familiar with basic concepts of supply and demand and knew how speculation could drive up fundamental commodities’ prices, which wreaks havoc on the economy and social order. Analyzing the Guanzi, a political document from the seventh century BCE, Weber reveals a profound historical legacy of managing markets. Crucially, the authors of the Guanzi were not arguing for direct repression of market forces, but for careful management of prices through the buying and selling of essential goods. This way, state officials could protect peasants against market fluctuations and speculators, stabilize prices, and generate state revenue without punitive taxation.


Fast-forward to the end of the Second World War, when the liberalization of strongly controlled war economies occupied the economic policy agenda. Weber shows how those arguing for gradual decontrol of prices (e.g., Galbraith) lost out to radical reformers in the U.S. The post-war debate about reforming the economy gave rise to neoliberal ideas that underlie shock therapy. For the likes of Hayek and Mises, there was no middle road between socialist hubris and capitalist bonanza: even a little bit of price regulation would eventually lead down a slippery slope toward totalitarian socialism. Thus, the state has to withdraw from regulating the economy as much and as quickly as possible. This Manichean juxtaposition of “good” free markets and “evil” central planning was key for the neoliberal reform proposals three decades later when the transformation of state socialist economies arrived on the agenda.


Weber also notes that the more careful approach of the U.K. led to different outcomes than the radical liberalization approach of the U.S. The U.K. managed to avoid a boom-bust cycle, did not face such a dramatic rise in inflation, and avoided the mass protests that erupted in the U.S. Weber also offers a provocative review of the German experience with post-war liberalization. While shock therapists lionize Ludwig Erhard for his radical stabilization and liberalization measures, Weber points out that his rapid decontrol of prices caused an upshot in inflation that resulted in a general strike. Shortly afterward, the German government decided to bring crucial segments of the German economy back under state control. Thus, the purported ordo-liberal success story of Erhard’s reforms was much more controversial than it appeared. Radical liberalization led to economic and social problems and was reversed in a short time. Nevertheless, distorted narratives about the German post-war financial experience continue to influence economic policy debates today.


The Chinese reform debate


The Chinese Communist Party’s success in bringing down inflation was crucial for its early legitimacy. Instead of repressing markets, state trading agencies – along the lines of the ancient practice outlined in the Guanzi – managed prices during early communist rule. However, the Great Famine between 1959 and 1961 overshadowed these early successes in economic stabilization. Forced industrialization and increased centralization of agriculture resulted in chronic food shortages and the death of tens of millions. Although partial liberalization of household production allowed the state to overcome the famine, most people in rural China continued to live in dire poverty.


When Hua Guofeng, Mao’s designated heir, started a gradual opening after the Cultural Revolution, the country’s intellectual and political elites realized how much China had fallen behind. Deep poverty and global economic insignificance were not compatible with their definition of socialism, so they started to look for ways to reform the economy. Though Hua is mainly known as an ardent follower of Maoism, Weber shows that he initiated a paradigmatic change in economic governance, paving the way for Deng Xiaoping’s reform agenda.

When Deng took over from Hua in 1978, he accelerated reforms. Deng shunned tight control of the economy and reoriented politics away from ideological-cultural debates toward facilitating economic development. A group of young social scientists and economists previously sent to the countryside during the Cultural Revolution for “reeducation” played a central role in these reforms (such as Chen Yizi, Xiaoqiang Wang, and Nanfeng Bai). During their forced rural stay, these economists became intimately familiar with the everyday realities of the Chinese countryside. Thanks to their urban intellectual and political connections, they had access to books and used their years in the villages to read up on the latest developments in the social sciences. They conducted surveys about the economic and social impact of household contracting, which played a crucial role in legitimizing gradual market reforms in agricultural production in the early 1980s.


The most prominent representative of this group of economists is Chen Yizi, founder of the Rural Development Group and later director of the Economic System Reform Research Institute. Chen emerged as the leader of this generation of young researchers. Invited to advise Deng and his political allies (Zhao Ziyang, Hu Yaobang), these researchers played a central role in devising the 1980s gradualist reform agenda. As Weber notes, for these economists and reformist politicians, “‘seeking truth from facts’ was not a mere epistemological principle but an art of government” (p. 162).


The first steps of the reform focused on extending household production and liberalizing agriculture. Mirroring the socialist second economy in Hungary and some other market-socialist countries, the state maintained its role as buyer of last resort, and owner of the land and heavy agricultural machinery. Yet, households gradually became responsible for organizing agrarian production. These reforms brought enormous gains in rural living standards. Fueled by this success, reform economists’ attention started to turn to the industrial core. Based on experiments and empirical investigation, they concluded that a cautious approach was superior to the risk of a policy-induced shock liberalization. They argued that the state should play a crucial role in stabilizing prices and protecting consumers and producers from violent cycles. The critical tool of these reforms was the dual-track price system that regulated production through state participation in the market.


Another group of more theory-oriented, mathematical economists also emerged, such as Lou Jiwei, finance minister from 2013 until 2016, or Wu Jinglian, one of China’s most well-known economists. Wu was a key translator of Friedman’s ideas and propagated Friedman’s story about the post-war German economic miracle. In this reading, “the so-called economic miracle produced by Ludwig Erhard in 1948 was a very simple thing. He abolished all price and wage controls and allowed the market to operate” (p. 130). These theoretical-mathematical economists became central proselytizers of neoliberal shock therapy and its theoretically-derived blueprints for radical reform. Gradual market reforms contributed to inequalities and corruption, and the shock therapists argued that this corruption stems from the fundamental incompatibility of the market and state planning. Inflationary pressures at the end of the 1980s provided another point of attack.


In addition to Western authority figures such as Friedman, Eastern European economists (such as Ota Šik, the architect of the economic reforms in Czechoslovakia, Włodzimierz Brus, the disillusioned Polish reform economist, or János Kornai, Hungary’s self-styled radical reformer) also played a central role in Chinese reform debates. Invited to China, these economists tried to convince their hosts that gradual reforms in Eastern Europe in the 1970s and 1980s were futile. However, for China’s gradualists, Eastern Europe’s laboratory experiments were proof that the only viable option for China was to avoid shock therapy and continue experimenting with markets at the periphery of the socialist economy, allowing state-owned companies to gradually “grow into the market.”


Twice did shock therapists try to gain the upper hand: in 1984 and 1986; gradualists debunked them on both occasions. However, by the end of the 1980s, Deng started to see radical reforms as the only way ahead because of growing corruption and inflationary pressures. His long-time ally, Zhao, was not convinced, and continued to argue for gradual opening. The Coastal Development Strategy that internationalized the dual-track price system in China’s coastal regions was a central building block of this gradualist strategy. For Zhao and his economist allies, the mounting inflationary pressure was not a sign of excess aggregate demand but a result of mismatches in different sub-spheres of the economy. They saw shock therapy as a threat to the socialist industrial base that they wanted to gradually modernize and transform into a competitive business sector.


Shock therapists argued that the only way ahead was to destroy the old industrial base and let the invisible hand of the market work its magic, which would create a new, much more efficient economy. For shock therapists, gradual tinkering with the socialist industrial base only prolonged the economic crisis and contributed to inflationary pressure. This resonated with the people’s fury at the corruption brought about by the dual-track system as well as with the rising, yet unsatiated, demand for political reform.


By 1987, Zhao gave up on his gradualist plan and aligned with Deng and the shock therapists. 1988 was supposed to be the year of rapid mass liberalization measures. However, inflation shot up partly because people knew about the state’s intention to terminate the dual-track system. Hence, they started panic buying, so the (intention of) shock therapy pretty much brought about its own demise. As panic buying ensued and unrest grew, Deng had to step on the breaks. Although the 1990s brought a renewed wave of liberalization, China never implemented anything even remotely resembling the post-Soviet shock therapy package.


The afterlife of the 1980s debate


Ironically, the political leaders and reform economists who engineered China’s gradual opening lost their voice and influence, ending up on the margins of history. The violent repression of the protests that culminated in the massacre of Tiananmen Square marked a turning point. Zhao Ziyang and the young economists he and Hu Yaobang nurtured, such as Chen Yizi, expressed their sympathies for the fledgling democratic movement. When the political leadership repressed the movement, this ended the career of the generation of reform economists allied with Zhao. Zhao himself spent his last years under house arrest while Chen Yizi fled the country. In contrast, shock therapists such as Wu Jinglian were better at the tactical game. They did not support the democratic movement and enjoyed stellar careers in the 1990s.


A critical theoretical insight that emerges in this book goes beyond the specific policy prescriptions of shock therapy or gradualism. It pertains to the nature of economics and its relationship to the social sciences. The key figures behind the gradualist policy approach were empirically-oriented development economists, utilizing methods and insights from sociology and other social sciences. They were intimately familiar with Chinese society, spent years in remote villages, and were skeptical of theoretical dogmatism, both Maoist and liberal. In contrast, the proponents of shock therapy believed in the superiority of computerized, mathematical economics. Instead of careful empirical observation and experimentation, they derived bold blueprints from neat theoretical models. This “armchair economics” suffered multiple defeats in China during the formative years of economic policy.


Economists today can still learn a great deal from the pragmatic, empirical orientation of Chinese gradualists. As Herbert Simon famously criticized neoclassical economists in the 1980s, “economists tend to start with some global theoretical assumptions as if they were handed down from the mountain by Moses, and then they reason from them. … No empirical evidence is given … [they] emerge from the mind of the economic theorist sitting in his armchair” (pp. 19-22). Since that time, economics has undergone a major empirical revolution. However, neoclassical economics still reigns supreme. Weber’s book shows that an economics sensitive to historical context, institutional specifics, and in dialogue with other empirical social sciences can yield superior proposals to armchair economics.


From this perspective, a more thorough contrast with Eastern European late-socialist economic reform debates would be intellectually rewarding. While in China, empirically oriented institutionalists converged on a gradualist reform agenda, in East-Central Europe, the economics landscape opened onto a different path. In Hungary, the country with the longest legacy of market-socialist reforms dating back to the 1968 New Economic Mechanism, leading institutionalists, such as Kornai, came to embrace the neoliberal outlook most forcefully represented by neoclassical-monetarist economists. At the same time, the remaining group of institutionalists – many of them following an interdisciplinary socio-economic approach – became marginalized by the 1980s. In short, even though gradual market socialist reforms had a long legacy in Hungary, the representatives of gradualism either converted to shock therapy or were marginalized.


The author’s decision to foreground price reform means she had to relegate privatization and industrial policy debates to the margins. This focus is unfortunate, insofar as the contrast with Eastern Europe’s reforms works best if we bring in industrial policy. China’s decision to modernize instead of destroying the socialist economic base contrasts with Russia’s mass privatization policy and the rapid external liberalization and deadly bankruptcy regulations introduced around Eastern Europe. The waves of deindustrialization and the mortality crisis that hit Eastern Europe, and to which Weber refers in the book’s introduction and conclusion, are as much rooted in neoliberal industrial policy as in radical monetary policy reforms. The most important challenge of the 21st century, the transition to a sustainable economy, also revolves around industrial policy. Teasing out the industrial policy lessons of China’s transformation would thus be an important addition – along the lines of the recent Financial Times essay Isabella Weber co-authored with Daniela Gabor about the perils of “carbon shock therapy” and the need for green industrial policy. We can only hope that the next book or article(s) will explore these topics in more detail.


It is also essential to see that China’s success is massive but still relative: China’s development model trumps Eastern Europe’s based on economic indicators. However, it has also kicked off a rapid growth of inequality and precarity, intensified ecological problems, and failed to facilitate democratization so far. In fact, it allowed for the emergence of a repressive surveillance state.


Another unresolved question is to what degree politics and political economy were central to China’s ability to avoid shock therapy. Did the differences in Russia’s and China’s power structures set the trajectory of economic policymaking, as Adam Tooze argues in his review? Political leaders favored gradualism over shock therapy not only to avoid chaos but also political liberalization. The radical elimination of the socialist economy would have threatened the power of the Communist Party. Would political leaders have been more open to radical marketization if it could have been combined with the maintenance of the party’s power? Put another way, to what degree did economic gradualism in China depend on the will to maintain political stability and the dominance of the party? More theoretically, is gradual reform of socialism possible under democratic rule? From another perspective, how is it that China has not democratized, even though the middle class is booming? These are big questions, and it would be enriching to know more about the author’s take on them.


These unresolved issues, however, do not diminish the extraordinary contributions of Isabella Weber’s book. The amount of research the author put into reconstructing the debates about price reform is astounding: from ancient Chinese texts to policy documents, conference memos, and first-hand interviews conducted in Chinese, the book rests on an immense empirical foundation. Another great added value of Weber’s book is how she amplifies the narrative of a forgotten and repressed group of social scientists and reform politicians, the key architects of China’s gradualist development model.


Isabella Weber’s extraordinarily detailed analysis of the economic policy debates around price reforms offers several lessons for today. Shock therapy has changed but market-fundamentalism is still on the agenda. The combination of historical depth with theoretical insights that also speak to contemporary debates makes How China Escaped Shock Therapy a benchmark monograph in the literature on the political economy of China and shock therapy.


Originally published on December 14, 2021, on the SASE blog: Future Directions of Socio-Economics, Society for the Advancement of Socio-Economics.