Role of Government in Economy

Role of Government in Economy

The emergence of China as a world power has given the world a new form of capitalism to evaluate. Deng Xiaoping first began to open the Chinese economy in 1978 and the rate of growth since that point has been nothing short of phenomenal. Even through the recent global economic crisis, China has outperformed, leaving the Western world in the dust. The Chinese economic growth story has not been one simply of free markets, however, but one characterized by some of the highest levels of state control in any capitalist economy. This is especially true in China's burgeoning cities, the home of much of the country's new wealth. Huang (2008), however, argues that "capitalism with Chinese characteristics" was more successful in its earlier days, where the level of state control was lower. There is also reason to believe that the particular types of state interference -- exchange rate manipulation in particular -- are not sustainable over the long run. This paper will examine the concept of totalitarian capitalism in comparison with the freer Western version in an attempt to understand what the ideal role of government should be in the economy.

The Western version of capitalism has long been considered to be the freest from government intervention. Governments in the West still hold a strong amount of influence over certain sectors -- agriculture, health care, public goods and infant industries among them. But the flow of goods, capital and people is relatively loose in the West. Though always in a state of flux, this economic system has been in place since at least the mid 1800s and has resulted in the greatest generation and distribution of wealth ever seen. On all fronts -- innovation, human development, economic growth and health -- the Western capitalist system has completely overhauled our quality of life.

Totalitarian capitalism is a form of capitalism that can emerge under a totalitarian regime, that is a regime utterly dominated by a single political party or ruler. In its early stages, Chinese capitalism resembled most other forms of totalitarian capitalism in the world. In totalitarian countries around the world, capitalism seldom moves beyond small scale entrepreneurialism. The state remains in control of virtually all big enterprise under such systems. These enterprises may interact with the outside world in a capitalist manner, such as in the United Arab Emirates, but they remain distinctly tilted towards the totalitarian side of the ledger. Other forms are largely capitalist; though guided by the heavy hand of government and often subject to strong protections from outside influence. This form, seen in Japan and South Korea, is oriented towards capitalism. The Chinese story is unique because it cuts down the middle, bearing strong distinct characteristics of both systems.

In its early years, the Chinese system focused on two key elements. One was the advent of small private businesses, and the other was on the privatization of state-run enterprises. Both of these forms contributed strongly to the growth of the nascent Chinese economy, and were able to do so relatively free of government intervention. Entrepreneurs, wary of being seen as too capitalist, characterized their businesses as collectives. The state -- a central government tied together by a disparate set of provincial governments through which most real power flowed -- primarily played the role of financier during these years. The result was strong growth and a diffusion of wealth throughout the country (the Economist, 2008).

As with all totalitarian states, China was won't to change its mind. After Tiananmen Square hinted that broad-based economic freedom threatened political and cultural freedom as well, the regime shifted its focus. State support for rural entrepreneurs dried up, and the focus of Chinese development shifted to large, state-run enterprise. This changed the course of economic development. While strong GDP growth has continued, the state has become progressively more involved in the development of the Chinese economy (Huang, 2008).

This vision of totalitarian capitalism borrows ideas about state funding and protection from the Japanese and Korean models and infuses them with strict currency controls and selective leveraging of capitalist ideas. Entrepreneurs now face increasing red tape, which has lead to a decrease in startup and innovation in China's major economic zones such as Shenzhen (the Economist, 2010). While the major corporations benefit from state protections and strong government ties, the most successful of them also benefit from access to Western-style capitalism. Lenovo is a major Chinese success story, but was controlled from Hong Kong; Wahaha and Haier have succeeded in part because they have been protected from government bureaucracy. State involvement in Huawei is at a very high level, indicating that other success stories are more the result of state control than of capitalism (the Economist, 2008).

In addition to firm-specific influences, totalitarian capitalism also relies on strong manipulation of the macroeconomy. China's famous currency manipulation has kept the value of the yuan artificially low, giving Chinese goods a competitive advantage overseas (Krugman, 2010). While Western capitalism does occasionally involve currency intervention, it also involves a free-floating currency, something that China does not have.

The nature of the differences between totalitarian capitalism and Western-style capitalism therefore are focused on the degree of government involvement. Totalitarian capitalism attempts to leverage some of the market forces of free market capitalism while retaining tight state control over the economy and over enterprise. The outcomes to this point have been impressive. The rate of economic growth in China has been nothing short of miraculous and Chinese firms are now beginning to emerge on the world scene thanks to their government protection. There are strong indications, however, that if China's growth story is to be sustainable, that country will need to forgo totalitarian capitalism for a more Western model. Over the short-term, China's model may have been highly successful, but over the long-term it creates disequilibrium that will ultimately lead to its failure.

Consider one of the most driving forces of capitalism -- innovation. In traditional free market capitalism, innovation is driven by necessity, which itself is driven by competition and the need to succeed. In China, innovation has slowed. A study of innovation in Shenzhen noted that while China is a leader in innovation among BRIC countries, it does not match the innovation levels of more developed economies (the Economist, 2010). This is because the totalitarian capitalism model does not include the two key drivers of innovation. There is limited real competition in China. In many industries, the government has created the facade of competition by splitting large state-owned enterprises into smaller enterprises, still under tight state control, that compete with one another only in theory (Williford, 2010). Government protection of large enterprise includes guaranteed financing from state-owned banks. Not only does this stifle innovation, but it creates the illusion of free enterprise. The Chinese government claims that the majority of that country's economy is in private hands, but those private firms are backed by state-owned governments (Roberts, Prasso & Clifford, 1999). The covenants and control mechanisms that come attached to the financing extend the degree of control that the state has.

Without strong innovation, the long-term future of China's growth is tied to other competitive advantages. At present, cost is that nation's primary competitive advantage due to its currency manipulation. This manipulation, however, is unsustainable. Pressure is already building on the United States and the IMF to address the issue of the undervalued yuan. Yet, even if no binding action is taken, eventually market forces will solve the problem in the same way they solved the problem of undervalued Southeast Asian currencies in the 1990s. While a strong centrally planned economy can survive the will of market forces for a long time, eventually collapse will come. When it does, China will be left with few competitive advantages, being neither an especially cheap place to do business nor one gifted with high end innovative skills.

The Western capitalist model has succeeded over the long run, in part because government involvement is left to areas where it can genuinely improve the economy -- the provision of public goods, regulation, encouragement of innovation and protection of infant industries. Totalitarian capitalism relies on other forms of government intervention such as state financing of private ventures and exchange rate manipulation. While these strategies have proven to work well in the short run, there is little evidence to support the idea that such strategies will succeed long-term.

Exchange rate manipulation is almost certainly a house of cards. The massive transfer of wealth that has resulted from the undervalued yuan is a threat to the world's economy, heralding a major potential collapse that will devastate all sensitive areas of China's economy. This would be reasonable if China was using the exchange rate manipulation to foster the country's nascent firms and industries, but the heavy hand of totalitarianism is simultaneously stifling innovation. Competition in China is less vibrant than it is in the West, and there is a strong safety net for the nation's large enterprises from the state-owned banks. This provides two strong disincentives to innovate. What is left is a Chinese state that discourages the development of the most tried-and-true means of economic development -- competition and innovation -- and instead relies on wealth transfer due to currency manipulation as the foundation of its success.