East vs Adam Smith

About Lan Xiaohuan's book "The Visible Hand: State and Economic Development in China"

The basis of the Chinese economic miracle of the late 20th century is the effective work of the state bureaucracy based on approaches that developed many centuries ago, says Chinese economist Lan Xiaohuan. Unlike the West with its invisible hand of the market, the East is accustomed to relying on the wisdom of a central authority that knows where the path to success lies. But sooner or later such a model faces self-limitations. Read about the book “The Visible Hand: State and Economic Development in China” in the material by Nikolai Kanunnikov.

All of us, since February 24, 2022, have found ourselves in the face of advancing barbarism, violence and lies. In this situation, it is extremely important to preserve at least the remnants of culture and support the values ​​of humanism - including for the sake of the future of Russia. Therefore, the editors of Gorky will continue to talk about books, reminding our readers that there is still a place for thought and fiction in the world.

Lan Xiaohuan. The Visible Hand: The State and Economic Development in China. M.: Gaidar Institute Publishing House, 2025. Translation from English and Chinese, scientifically edited by Ilya Chubarov. Content

Made in China

In 1987, John Adams' opera Nixon in China premiered at the Wortham Theater Center (Houston, USA). In an epic manner unusual for Adams, it tells how the leaders of the largest countries of the two hemispheres met in Beijing in 1972: US President Richard Nixon and Chinese President Mao Zedong. Although the opening of the People's Republic to the world was still several years away, the seeds of globalization had already begun to sprout on Chinese soil.

The status of the world's factory, which China acquired through a fortunate combination of political and market circumstances in the 1980s and 1990s, can only partly explain the stunning economic successes of the PRC. An outside observer sees the tangible results of these rapid changes: huge production facilities, mountains of goods from clothing to equipment with Made in China labels. But behind all these achievements lies the many years of work of the Chinese bureaucratic machine.

Economist Lan Xiaohuan, after studying at the University of Virginia, USA, returned to his homeland, where he teaches at Fudan University. Like many experts and ordinary people, he wondered: how did China manage, in just a few decades, from a backward agricultural country to become a leading industrial power trampling on the world's heavyweights? Armed with economic theory, he wrote the book “The Visible Hand” (a kind of antithesis to Adam Smith’s invisible hand of the market) - about how the state not only distributed pieces of the pie of general welfare, but also participated in its preparation.

Xiaohuan is a Chinese man who wrote a book for ordinary Chinese people, and you don't need to be an expert in economics or political science to understand it. Those familiar with the theory will, of course, note how interestingly Xiaohuan uses well-known concepts, such as economies of scale, externalities, the principal-agent problem, and others. First, he looks at how the Chinese management system is structured at the micro level - who is responsible for what and at what stage - and then shows what results such state architecture leads to at the macro level - from soaring prices for new housing to trade wars.

Vertical of economic power

China is a large and diverse country. Therefore, historically, the role of individual regions in it is great, and in order to maintain the integrity of the economic space, the government must somehow connect territories that are not similar to each other either culturally, demographically, or geographically. For this, writes Xiaohuan, a vertical management system with strict subordination has been created in the People's Republic: the central government - provinces - city districts - counties - volosts. At each level there are executive authorities that overlap with each other, for example, the national Ministry of Finance directs and controls the county financial department. The scope of authority at different levels of government is based on three principles: accounting for externalities, processing complex information, and aligning incentives. These principles can be reformulated into questions, the answers to which determine which floor is responsible for implementing certain provisions of public policy: what are the limits of influence of the measures taken, who collects and monitors information about the progress of work, and who is responsible for their implementation? Xiaohuan notes that this approach developed centuries ago and in the twentieth century was only supplemented by the level of urban districts and the intervention of the central government in the life of counties and volosts.

The main task of the regions is to attract industrial companies that can become residents of industrial parks. Preparing such spaces is not cheap, which means it is extremely important for the region to find money to prepare the infrastructure. One of these ways is tax revenue. In the 1990s, China quickly said goodbye to the remnants of a planned economy and in 1994 divided all taxes into three groups - national, local and joint. Initially, almost all VAT and income taxes went to regional budgets, which prevented the creation of a single economic space and undermined the powers of the center. Gradually, Beijing, through long negotiations with the regions, accompanied by mutual concessions, again gained control over a significant part of tax revenues. The recipe for the Chinese economic miracle of the late twentieth century, writes Xiaohuan, is simple: a tax system aimed at industrialization + worker discipline + outsourcing of global production chains. By the beginning of the 21st century, Chinese regions had lost almost all tax instruments for attracting companies, but retained the right to dispose of land. To prepare it for an industrial park, the government of a particular province creates investment platforms - companies that can receive light and large loans under government guarantees for primary (resettlement of old houses, preparation of sites) and secondary (conducting new communications, construction of commercial housing) development. Since the government assumes all obligations to repay debts, platform companies that stimulate the economy can be incredibly heavily leveraged. A relaxed attitude towards debt is a hallmark of Chinese economic policy. In addition, investment platforms have external effects: even if the project itself is unprofitable, its impact on the local market can be so significant that it covers the costs. This model works especially well when reconstructing historical city centers.

Consequences of an economic miracle

If in the first part of the book Xiaohuan answers the question of how the Chinese state managed to become one of the main engines of economic growth, then in the second he offers to look at this story from a different perspective. Now he is no longer interested in the origin of the Chinese economic miracle, but in its consequences. What happens when institutions that have ensured the development of a country for decades begin to face the limits of their own effectiveness?

Soaring real estate prices, growing regional debts, high social inequality or foreign trade imbalances are not isolated symptoms of local crises, but signs of wear and tear of the existing development model. This view helps to change the reader's optics: instead of a set of market/state failures, he now sees the evolution of institutions.

This idea is most clearly revealed in discussions about urbanization. The rapid growth of Chinese cities was one of the most important tools for industrialization. Government investment in roads, subways, industrial parks, and new residential areas increased land values, and revenues from the sale of land use rights were again used to develop infrastructure, which in turn attracted businesses and residents. This closed loop allowed China to implement, over the course of several decades, the largest urban construction program in modern history. But at the same time, he made regional finances extremely dependent on the real estate market.

Investment platforms created by provincial authorities have provided financing for large-scale infrastructure projects for many years. However, as economic growth has slowed, the issue has shifted from the volume of borrowing to the efficiency of its use. Previously, every new bridge, port or industrial park increased wealth, but today the return on such investments is noticeably declining. In other words, it is not so much the model itself that is changing, but the conditions in which it has to work.

This idea is also important for understanding the nature of inequality in the People's Republic. Its source is the very institutions of the Chinese economy, for example, the population registration system ( hukou ), land relations, the structure of regional budgets, and the peculiarities of the housing market. That is why reforming one area, writes Xiaohuan, will inevitably affect all others. Institutions form an interconnected system, and it turns out to be impossible to change a single element without changing the entire structure.

Specialists in catch-up development are interested in examples of either overly unsuccessful countries or overly successful ones. The Chinese case falls into the second category, and for Xiaohuan, the modern economic history of the PRC represents a kind of analytical testing ground. As you read, it becomes clear that the author is talking not so much about China, but about the nature of economic development in general. Any model that can provide rapid growth to society begins to create its own limitations over time. A state that has managed to organize industrialization inevitably faces the need to change the management tools of an already developed economy. Economic development cannot be understood by looking only at results, no matter how impressive they may be. It can only be understood by observing how institutions emerge with the help of the state, what incentives they create for agents, and why the success of yesterday's reforms inevitably becomes the starting point for tomorrow's reforms.