Leslie Young Authors

Central Planning versus Market Economy: A False Dichotomy

October 20, 2015

Contrary to popular perception, China’s central planning did not fail. Here’s why the Five Year Plans have played an important role in China’s progress.

A common view of China’s central planning is that it has failed; since China grew faster when its reforms replaced planning with markets, the sooner China gets rid of Five Year Plans the better. This view is simplistic.

Firstly, central planning did not fail: in the central planning era (1952-1978), China achieved a real growth rate per capita of 3% per annum, which is comparable to that of the US over the same period. A private enterprise economy requires a tax system to extract revenue to fund the state, financial institutions to channel savings into investment, plus accounting and legal institutions to ensure good corporate governance. Russia’s switch from central planning to a market economy in the 1990s was aborted by its failure to build these systems, despite high literacy, excellent education and decades of peace and social stability. China could not have built these systems soon after 1949, given its much lower literacy, poor education and the chaotic aftermath of decades of war.

Central planning was the fastest way for China to mobilize capital and labor for industrialization. By imposing low wages and high product prices, the central plan ensured profits for state enterprises, which could be used to fund government and investment. The same considerations had led Japan to use central planning and state enterprises to launch industrialization during the Meiji Restoration. Central planning also limited the autonomy of enterprise managers, hence their incentive and ability to use local information. This was regrettable, but not fatal when the overall direction in which China needed to develop was pretty clear. However, central planning also limited the autonomy of managers to loot their enterprises, the problem that fatally undermined Russia’s economy when it exited central planning without institutions to ensure good corporate governance.

Secondly, China’s transition from a planned to a market economy was smoothed by their parallel operation for a number of years. All state enterprises and all farmers had to fulfill their obligations under the central plan, but could sell any surplus into private markets. This policy was important in economic terms because it maintained employment, livelihoods, infrastructure and the supply of basic goods, hence a stable foundation for the nascent market economy. The policy was important in political terms because it ensured that the early reforms created no losers, only winners, so that no interest groups—such as local party leaders—sought to stymie or disrupt the reforms.

Leslie Young, Professor of Economics, CKGSB

Thirdly, even when private enterprise became a leading force, central planning enabled the integration of microeconomic with macroeconomic policy. This is illustrated by the Five Year Plan of 2011-2015, which was praised by most external as well as most internal observers. It sought to guide China away from the previous growth model based on exports and investment toward a model based on consumption and services. But it also sought to maintain growth and employment by promoting market forces in the allocation of capital, while restricting the growth of local government debt. The Plan provided a useful guidesheet for a complex transition, while allowing room for judgment by the leaders of enterprises and local governments.

However, the fate of the current Five Year Plan shows the limitations of planning in China today. The plans to promote market forces in finance went awry as the stock market suffered first a bubble then a collapse, which the government tried to rectify with massive interventions. In the meantime, China’s exports were set back by recessions in the European Union and major emerging markets, especially Brazil and Russia. Priority had to be given to maintaining growth and employment by centrally-organized backdoor interventions in capital markets.

These setbacks reveal that the basic problem facing China’s planning system today is macroeconomic rather than microeconomic. Planning can facilitate innovation and economic dynamism by opening up more space for private enterprise, for example, by extending the protection of intellectual property rights and encouraging venture capital funds; both policies feature in the current Five Year Plan. However, successive reforms have liberalized capital markets and allow banks greater scope to make decisions based on profit. This has left financial flows and the macroeconomy more exposed to both internal and external shocks, which can disrupt the execution of central plans, however intelligent.

Ironically, it is outside of China that centralized planning remains possible—and desirable. The “One Belt One Road” strategy uses China’s foreign exchange reserves to fund direct investment around the world, both to improve China’s access to natural resources and global markets and to use up excess capacity in heavy industry. These projects are capital intensive, fraught with political risk, link many industries and deploy hundreds of thousands of Chinese citizens abroad. As in the first era of central planning, they require political leadership, central coordination of state enterprises and workers, and funding via state banks. However, they must also allow micro-decisions to be made locally, since central planners are certainly not capable of processing all the relevant information from around the world. So long as the state keeps a grip on heavy industrial enterprises and the allocation of finance, there will be a role for this looser form of planning.

Leslie Young is Professor of Economics at CKGSB.

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