The Industrial Policy Debate of 2016: Zhang Weiying on Entrepreneurs and Innovation (Part 2)

"[One could also say] ‘there hasn't been a long-lived individual who has never fallen ill.’ But could we seriously infer from this that illness is the cause of longevity?" — Zhang Weiying

This is the second part of the landmark “industrial policy debate” between Zhang Weiying and Justin Yifu Lin, held in 2016. Part One, which covers Lin’s arguments in favour of industrial policy, can be found here.

Along with Fan Gang, Zhang Weiying is China’s most prominent representative of the neoliberal economic thought now at odds with the prevailing policy direction. For many years, however, he enjoyed a reputation as one of China’s most influential economists. While working in the State Commission for Restructuring the Economic System in the 1980s, he became closely associated with the dual-track pricing system, widely regarded as a crucial factor in distinguishing China’s relatively stable market transition from that of the Soviet Union and its former republics.

Nonetheless, by the late 2000s, Zhang and other neoliberal economists of the “New Right”—a label given by their detractors—were already coming under criticism amid mounting resentment at the social inequality that economic growth had brought in its wake. His removal as Dean of Guanghua School of Management at Peking University in 2010 was viewed as a symbol of their decline. Zhang remains a conspicuous critic of the renewed emphasis on state direction in economic policy. In a speech last year, he argued that the Chinese economy faces “directional problems” (道的问题), meaning that tools for resolving “technical problems” (术的问题)—such as adjusting monetary policy—will not have the desired effect.

In his telling, the structures of free trade once provided the arena for China’s spectacular advances following its integration into this system through reform and opening-up. Now, as enterprises operating under the rules of “Chinese characteristics” are in their turn “conquering the world” (征服世界), he worries about the reverse phenomenon occurring—other states “conforming to local practice” (入乡随俗) and adopting similar policies to those of China. Others have echoed these concerns, albeit from standpoints more sympathetic to industrial policy. The trade economist Ma Xiaoye once cautioned that the prospects of economic frameworks such as Justin Yifu Lin’s New Structural Economics depend on convincing foreign markets that they do not constitute a change to normal market competition.

A related concern that Zhang has re-articulated in recent years is the concept of the “latecomer’s disadvantage” (后发劣势), first proposed in 2001 by the economist Yang Xiaokai. Yang argued that the ability of late-developing nations to make rapid early gains by imitating existing technologies can foster over-confidence in a set of institutions—such as the “China model”—that need reform for sustained increases in prosperity. Zhang holds that an innovation system based on state-distributed rewards will blunt entrepreneurial instincts and waste resources in the long-term. Picking up Lin’s analogy of the need for institutions to reward “the first person to eat a crab”, he quips that anyone who requires state subsidies to innovate is “merely striking the pose of eating a crab while actually gnawing on a steamed bun.”

— James Farquharson

Key Points

1. Entrepreneurs should not be regarded as mere “calculators” that can be manipulated effectively by government incentives; they act through “imagination, acumen and judgement”.

2. That is why they are essential to solving market problems and driving innovation, which cannot be achieved by “locking oneself onto a pre-determined path”.

3. Industrial policy is essentially the “planned economy in disguise” and will only lead to overcapacity in certain areas and shortages of consumer goods.

4. China’s progress since reform and opening-up owes more to private innovation and cross-border capital flows than government support.

5. Subsidies will simply “cloud the eyes of entrepreneurs”, turning them into rent-seekers rather than genuine innovators—ultimately harming innovation.

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6. Entrepreneurs are better than governments at identifying “dynamic comparative advantage”; on the occasions where governments have backed successful industries, those industries usually succeeded in spite of the intervention.

7. It is impossible to know with accuracy where future innovation will lead; risk is therefore best spread across diverse innovation pathways in the marketplace, rather than concentrated upon a few chosen by the government.

8. Decisions made by government agencies are likely to be swayed by established interests and result in mistakes; the complexity of government makes it virtually impossible to design an incentive scheme to counter this.

9. Once a mistake has been recognised, governments tend to seek to conceal it by pouring even more money into the project—thereby compounding the waste of public funds.

10. The limitations of government can thus be summarised as “human shamelessness” and “human ignorance”; the only remedy is to prevent its powers from extending beyond a certain sphere.

The Scholar

Name: Zhang Weiying (张维迎)
Date of birth: 1959 (age: 65/66)
Position: Boya Distinguished Professor and Professor of Economics at the National School of Development (NSD)
Formerly: Research fellow at the Economic System Reform Institute, under the former State Economic System Restructuring Commission (1984-1990), since dissolved within the National Development and Reform Commission (NDRC); Dean of Guanghua School of Management at Peking University (2006-2010); Assistant President of Peking University (2002-2013)
Research focus: Macroeconomics; Economic Reform
Education: BA-MA Northwest University in Xi’an (1979-84); MA-PhD Oxford University (1990-94)
Experience Abroad (visiting scholar): City University of Hong Kong (various points in 1996-1998); Tokyo University (December 1997); The Australian National University (February 1998); Seoul National University (December 1998)

THE “GREAT INDUSTRIAL POLICY DEBATE” BETWEEN ZHANG WEIYING AND LIN YIFU
Arguments from Zhang Weiying (张维迎)
Published by The Paper on 21 November 2016
Parsed and put together by James Farquharson
(Illustration by OpenAI’s DALL·E 3)

N.B. The following is a condensed overview of Zhang Weiying’s arguments from a 40,000 character debate transcript.

1. Hayekian vs. Neo-Classical Market Theory

• Contrary to Justin Yifu Lin’s “neo-classical” understanding of market mechanisms—where negative externalities must be corrected by regulators—the Hayekian interpretation casts entrepreneurs as market adjusters, addressing problems by discovering market imbalances [不均衡] and opportunities for arbitrage [套利] [Note: Zhang calls himself an adherent of “Mises-Hayek” economic theory].

• In the neo-classical model, entrepreneurs have “no room to use their weapons” [毫无用武之地] and are reduced to mere “calculators” [计算器] that can be controlled by preset targets on the basis of rational and controllable motives.

  • Zhang: “[For an entrepreneur,] such strategic decisions [based on neoclassical economics] require no imagination, acumen or judgement. Yet for a true entrepreneur, imagination, acumen and judgement are what matter most.”

• Entrepreneurs and inventors are driven more by a long-term vision of changing the world than by the pursuit of marginal profits [边际收入]; the more significant the innovation, the truer this holds.

  • Zhang: “Innovation is not an issue of margins but rather one of life and death [生与死]—or, as Yang Xiaokai put it, it is an ‘infra-marginal issue [超边际问题]’.”

2. The Role of Entrepreneurs

• A market system that fosters innovation, solves problems and responds to society’s needs depends on the Hayekian principle of the “independent efforts of the masses” [众人的独立努力]; it cannot be created by “locking oneself onto a predetermined path” [将自己锁定在预定的路径上].

  • Zhang: “My differences with Lin Yifu on industrial policy stem in large part from our conception of entrepreneurs.”

• The complexity of China’s internal variation—and even intra-provincial differences, such as those between Shaanbei, Shaannan and Guanzhong within Shaanxi province—makes entrepreneurs essential for mediating adjustments across regions.

• Industrial policy is merely the planned economy in disguise [穿着马甲的计划经济] and its implementation will lead to structural distortions [结构失调] and overcapacity [产能过剩] in areas where there is insufficient demand.

  • Zhang: “Since the 1980s, examples of failed industrial policies in China have been countless [比比皆是], while successful ones have been few and far between [凤毛麟角]—a point that even Lin Yifu does not deny.”

• Compared with an economy driven by entrepreneurs, government policymakers make poor market adjusters and struggle to ensure an adequate supply of consumer goods.

  • Zhang: Under the planned economy, the State Planning Commission [国家计委] and the State Economic Commission [国家经委] were kept endlessly busy [整天忙得团团转], yet production enterprises were constantly in distress [时时告急] and consumer goods were in chronic shortage [处处短缺]. Under the market economy, by contrast, whatever we need is available.

3. Subsidies and Market Distortion

• It is a logical fallacy to argue, as Lin does, that “I have still not seen an example of a developing country that did not employ industrial policy and yet caught up with developed countries”.

  • Zhang: “[One could also say] ‘there hasn’t been a long-lived individual who has never fallen ill.’ But could we seriously infer from this that illness is the cause of longevity? Why not, instead, consider the many who have died from illness?”

• Subsidies and other non-universal measures—such as financing, loans, import/export licences, tax incentives and discriminatory market access—distort markets and encourage rent-seeking by those in power.

  • Lin, while adamant about not advocating subsidies, nevertheless speaks positively of policies such as tax benefits and has even argued in favour of “financial distortion” [金融的扭曲] to reduce the cost of capital for state-owned enterprises.

• Subsidies will “cloud the eyes of entrepreneurs” [迷糊企业家的眼睛] and “tempt [them] into rent-seeking”[勾引企业家寻租].

  • Zhang: Entrepreneurs take risks out of conviction and vision, not calculation. Anyone willing to innovate only with government subsidies is, at best, a rent-seeker and scarcely counts as an entrepreneur at all.

• In response to Lin’s analogy of rewarding “the first person [ever] to eat a crab” [第一个吃螃蟹的人]:

  • Zhang: “I have not studied humanity’s history of eating crabs, but I am sure the first person to do so was driven by a risk-taking impulse to taste a delicacy, not by a subsidy from the government or anyone else …[Subsidies] tempt many people to pretend they are eating a crab, but they are merely striking the pose of eating a crab [假装吃螃蟹] while actually gnawing on a steamed bun [拿出吃螃蟹的姿势啃馒头].”

4. The Problem with State-Identified Comparative Advantage

• Comparative advantage is a natural principle that people follow intuitively; it requires no government assistance or direction.

  • Zhang: “Just now, I was very surprised when Lin Yifu said that entrepreneurs don’t focus on comparative advantage. I believe only an idiot would go against comparative advantage [只有傻子才会违反比较优势]. A blind person becoming a storyteller or masseur [瞎子说书、盲人按摩] is a classic example of employing comparative advantage. The very fact that Lin Yifu and I are debating industrial policy today is itself [an exercise of] our comparative advantage—why would we debate quantum communication satellites instead?”

• The role of government in China’s development after reform and opening-up has been exaggerated; progress was driven by economic liberalisation, privatisation and internationalisation, owing little to the government’s development strategy.

• Foreign capital exports [外资出口] make up half of China’s exports [Note: this refers to exports from China by foreign-invested or foreign-owned enterprises; this is true for 2016, though by 2024 the share had fallen to 30% as total exports increased]. An open economy allows foreign investment to flow to where it is needed, rather than having the government identify which sectors possess comparative advantage and then subsidise their development.

  • Lin takes a different view of the importance of foreign investment, noting that even at its peak—after Deng’s “southern tour”—it accounted for only 10-15% of total investment in China.

• Lin’s schematic framework for identifying comparative advantage vastly underestimates the complexity of making investment decisions.

  • Zhang: “According to the theory that comparative advantage is determined by factor endowments [要素禀赋—Lin’s theoretical basis for ‘latent comparative advantage’], Japan in the 1950s should not have developed its steel, automobile or electronics industries; South Korea in the 1960s should not have developed its automobile industry; high-tech and agriculture would not have become Israel’s competitive sectors; nor would Yiwu in Zhejiang have emerged as a global distribution centre for small commodities.”

5. How Entrepreneurs Create Comparative Advantage

• Entrepreneurs are needed to discover “dynamic comparative advantage” [动态比较优势]. Because of its fluctuating nature, it is impossible for the government to determine consistently and accurately how best to allocate investment.

• In the case of the US car industry, it was the managerial innovation of Fordism that gave it an advantage over France and Germany, rather than any form of comparative advantage identifiable a priori.

• Contrary to popular belief, the Japanese and Korean car industries were not created by industrial policy but by entrepreneurs such as Chung Ju-yung, the founder of Hyundai, and Soichiro Honda in Japan; their success rested not just on their innovations, but also on their ability to resist state intervention.

• In cases where the government invested in industries lacking a foundation in entrepreneurial activity, industrial policy produced failures such as the Fifth Generation Computer Systems project in Japan.

• When governments do “strike a lucky hit” [歪打正着] and its industrial policy investments do pay off, it is often in industries that run completely counter to the principle of comparative advantage advocated by Lin.

  • Zhang: “The Japanese government targeted industries with relatively high income elasticity of demand [收入弹性], such as machinery, electronics and automobiles, rather than those where Japan held a comparative advantage, such as textiles.”

• The development of the cotton industry in Britain during the 18^th Century is another example of this:

  • In Zhang’s reading, the government banned cotton imports from India—and even the wearing of cotton textiles—to protect the domestic wool industry; this inadvertently led to the rise of the domestic cotton industry, spurred on by entrepreneurial advances in loom technology.

6. Epistemic Limitations on Government-Led Innovation

• Effective industrial policy is undermined by the “limitations of human knowledge” [人类认知能力的限制] and the risk of “distortions in incentive structures” [激励机制扭曲]—such as moral hazard and rent-seeking.

  • Zhang: “Put more plainly, one reason is human ignorance [人的无知]; the other reason is human shamelessness [人的无耻].”

• Though markets certainly have problems, these are only compounded by the involvement of government officials—who share all the faults of entrepreneurs while lacking their advantages of perception and judgement.

  • Zhang: “Lin Yifu, on the one hand, paints market failure [市场失灵] in bold strokes [浓墨重彩], while on the other, only lightly sketching out [轻描淡写] government failure [政府失灵]. In his theory, government officials are omniscient, omnipotent and utterly selfless beings who exist solely to serve others!”

• Governments cannot foresee undiscovered trends as entrepreneurs do through experimentation, because “innovation has no statistical law to be followed” [创新没有统计规律可循]; those who analyse why certain innovations succeed are merely “post-hoc Zhuge Liangs” [事后诸葛亮].

  • Zhang: “We neither know where the goal lies nor where the path is; we can only move forward through constantly correcting our mistakes.”

• Because the chances of success in innovation are small, the market is essential for spreading risk across multiple innovation pathways rather than concentrating it on just one.

• The electric fan industry in the 1980s illustrates the risks of industrial policy:

  • Zhang recounts how China’s government followed the advice of economists to develop certain “pinpointed” [定点] enterprises in the electric fan industry—which “expanded in a blind rush” [一哄而上]; in fact, they had underestimated prior production levels, and the arrival of cheap air-conditioning units soon transformed the entire market.

7. Corruption and Vested Interests

• It is impossible to ensure that subsidies and tenders are distributed on a “scientific” basis; decisions will inevitably be the “result of a contest between interests” [利益博弈的结果] and lead to rent-seeking.

• The complexity of government—with agents pursuing multiple goals and officials being “shuffled back and forth like running-horse lanterns” [像走马灯似的换来换去]—makes it impossible to obtain sufficient information to design an incentive system at a granular level.

• The only remedy is to establish “limited government” [有限政府] and clearly delimit officials’ powers through process-based supervision [程序性监督].

• Even if it were possible to design an incentive system to address “human shamelessness”, it could never overcome “human ignorance”—the constraints on human knowledge.

• Rather than failing in a given enterprise and moving on—as an entrepreneur operating within market mechanisms would do—government is more likely to double down on its mistakes and “conceal errors” [掩盖失误] by pouring even more support into the project.

• The project to develop 3G in China is an example of this:

  • The decision to adopt the domestically developed TD-SCDMA standard as the technical basis for the construction of China’s 3G network was made against the advice of leading telecommunications companies and some government officials, but owing to an obscure mix of vested interests, “the top leader rapped the gavel” [最高领导拍板], and China Mobile adopted the standard. [Note: scholars have suggested that desire to avoid dependence on foreign technology, as well as networked interests in the decision-making process, lay behind this decision].

  • This proved to be a mistake, but “all opposition voices were silenced” [所有的反对意见一律封杀] because China’s 3G network had been made a showcase of the objective to build an “innovative country” [创新型国家]. To cover the mistake, next-generation 4G was rolled out prematurely, long before the newly-built 3G network was anywhere near usage saturation, “wasting thousands upon thousands [数千上万] of millions in public funds”. It was only in 2014 that an article by Caixin exposed the scale of the waste [Note: the network was built in 2008-10; Caixin reports the total expense at 200 billion RMB].

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