Research Division Federal Reserve Bank of St. Louis Working Paper Series The Making of an Economic Superpower ―Unlocking China’s Secret of Rapid Industrialization Yi Wen Working Paper 2015-006B http://research.stlouisfed.org/wp/2015/2015-006.pdf June 2015 FEDERAL RESERVE BANK OF ST. LOUIS Research Division P.O. Box 442 St. Louis, MO 63166 ______________________________________________________________________________________ The views expressed are those of the individual authors and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis, the Federal Reserve System, or the Board of Governors. Federal Reserve Bank of St. Louis Working Papers are preliminary materials circulated to stimulate discussion and critical comment. References in publications to Federal Reserve Bank of St. Louis Working Papers (other than an acknowledgment that the writer has had access to unpublished material) should be cleared with the author or authors. The Making of an Economic Superpower 1 ―Unlocking China’s Secret of Rapid Industrialization Yi Wen Federal Reserve Bank of St. Louis & Tsinghua University (This Version: June 15, 2015) Abstract The rise of China is no doubt one of the most important events in world economic history since the Industrial Revolution. Mainstream economics, especially the institutional theory of economic development based on a dichotomy of extractive vs. inclusive political institutions, is highly inadequate in explaining China’s rise. This article argues that only a radical reinterpretation of the history of the Industrial Revolution and the rise of the West (as incorrectly portrayed by the institutional theory) can fully explain China’s growth miracle and why the determined rise of China is unstoppable despite its current “backward” financial system and political institutions. Conversely, China’s spectacular and rapid transformation from an impoverished agrarian society to a formidable industrial superpower sheds considerable light on the fundamental shortcomings of the institutional theory as well as mainstream “blackboard” economic models, and provides more-accurate reevaluations of historical episodes such as Africa’s enduring poverty trap despite radical political and economic reforms, Latin America’s lost decades and frequent debt crises, 19th century Europe’s great escape from the Malthusian trap, and the Industrial Revolution itself. Keywords: Industrial Revolution, the Rise of China, the Great Divergence, Market Fundamentalism, Neoliberalism, Big Push, Import Substitution Industrialization, Shock Therapy, Washington Consensus, New Structuralism, New Stage Theory. 1 This article is based on my book (in progress) with the same title. I would like to thank Costas Azariadis, Ping Chen, and Bill Gavin for strong encouragement and insightful comments on an earlier version of this project. Thanks also go to Jess Benhabib, Belton Fleisher, Nancy Stokey, Yong Wang, Yang Yao, Xiaobo Zhang, and Tian Zhu for kind comments and critics, and Maria Arias and Jinfeng Luo for able research assistance. My greatest gratitude goes to George Fortier, who has carefully edited the entire manuscript and provided numerous suggestions to improve the exposition of the ideas presented herein. Several ideas presented in this paper also exist in the related literature, and I have cited the original sources for all previously published content that I am aware of. But limitations in my knowledge and survey of the literature may have caused unintended omissions. Therefore, I welcome and appreciate feedback from readers who can identify any omitted or incorrect citations. 1 Table of Contents “Poverty or backwardness or the lack of industrialization is always and everywhere a social coordination-failure problem. The problem arises because of the enormous costs of creating market and its fundamental pillar—social trust.” “The ‘free’ market is not free. It is a fundamental public good that is extremely costly to create. The ongoing industrial revolution in China has been driven not by technology adoption, per se, but instead by continuous market creation led by a capable mercantilist government.” “The Glorious Revolution did not make British government more ‘inclusive’ in the sense of sharing political power with the working class (as glorified by Acemoglu and Robinson (2012, p.1-5) in their appraisal of the Arab Spring movement). It simply made the government more authoritarian and powerful in levying taxes, creating markets and commercial networks, promoting manufacturing and mercantilist trade, and reining over the British economy.” “The market for mass-produced industrial goods cannot be created by a single ‘big push’ under import substitution or ‘shock therapy.’ It can only be created step by step in the correct order (sequence). China’s rise to global economic supremacy has been unstoppable because it has found and followed the correct recipe (sequence) of market creation, in contrast to its earlier three failed attempts at industrialization between 1860 and 1978 under different political systems.” “The degree of industrialization is limited by the extent of the market. The fundamental reason the United Kingdom, instead of the Netherlands, kick-started the First Industrial Revolution was because of its successful creation of the world’s largest textile market and cotton-supply chains in the 18th century, which made the nationwide adoption of the spinning jenny and factory system profitable and inevitable. Likewise, the fundamental reason the United States, instead of France or Germany, overtook the U.K. to become the next economic superpower was the U.S. government’s help in creating an even larger manufactured-goods market in the 19th century, which nurtured the world’s greatest inventors such as Thomas Edison and industrial giants such as Andrew Carnegie, Henry Ford, J.P. Morgan, John D. Rockefeller, and Cornelius Vanderbilt. Today, China (instead of India) is well-positioned to overtake the United States in manufacturing and technological innovations in the 21st century because the Chinese government has helped create a gigantic market that is several times larger than the U.S. market.” “Democracy cannot function without industrialization. Industrialization is impossible without a strong state.” Yi Wen (The Making of an Economic Superpower) 2 Abstract .......................................................................................................................................... 1 1. Introduction ........................................................................................................................... 4 2. Key Steps Taken by China to Set Off an Industrial Revolution ..................................... 18 i. Food Security and the Malthusian Trap ............................................................................. 18 ii. A Primitive Agricultural Revolution ................................................................................. 25 iii. A Proto-Industrialization in the Rural Areas ..................................................................... 28 iv. Ideological Shift toward Commerce and Commercialism ................................................. 35 v. Mercantilist Governments as Market Creators .................................................................. 40 vi. Corruption, Chinese Style .................................................................................................. 48 vii. Lessons and the Central Questions of Development ...................................................... 53 3. Shedding Light on the Nature and Cause of the Industrial Revolution ......................... 66 i. The Nature of the Firm ...................................................................................................... 66 ii. The Indian Textile Syndrome ............................................................................................ 68 iii. The Rise of the Textile Industry and the Logic of the English Industrial Revolution ....... 76 iv. The Industrial Trinity and the “Nature and Cause” of the Industrial Revolution .............. 87 4. Why Is China’s Rise Unstoppable? .................................................................................... 95 i. Correct Development Strategies ...................................................................................... 100 ii. “Learning by Doing”—The Ultimate Source of Technological Innovation .................... 107 iii. A Capable Mercantilist Government as Market Creator ................................................. 115 5. What’s Wrong with the Washington Consensus and the Institutional Theory? ......... 127 i. A Little Bit of Theory: The Fundamental Theorems of Welfare Economics .................. 127 ii. The Washington Consensus as Antithesis of ISI ............................................................. 135 iii. Such Theories Are Economically Misleading ................................................................. 140 iv. Such Theories Are Politically Naïve ................................................................................ 142 6. Conclusion: A New Stage-Theory of Economic Development....................................... 154 References .................................................................................................................................. 171 3 1. Introduction China’s sudden emergence as an economic superpower has astonished the world. Even as recently as 15 years ago (say, around the 1997 Asian financial crisis), few