Institutional innovation pathway to growth
Zhu Qiwen  Updated: 2004-08-27 08:25

With "innovation" the watchword, China today is bent on pressing ahead with overall reforms.

"To cross the river by feeling the stones" has proved a successful development approach which has conformed well to the country's realities these past 25 years.

However, challenges are mounting as the country deepens reform efforts to address many underlying and emerging institutional problems.

US economist Douglass C. North, a Nobel Prize laureate in economics, recently made a speech on the relationship between institutions and economic performance at the China Centre of Economic Research of Peking University.

Though much of his argument was based on the modern ascendancy of the Western world from a historical perspective, his stress on necessary institutional changes merits attention from Chinese policy-makers.

Fundamental shifts

North has attributed the rise of the Western world to a fundamental shift on the focus of institutional change from dealing with the uncertainties of the physical environment to dealing with the uncertainties of the increasingly complex human environment.

He believes that improving economic performance means lowering production and transactional costs and the key is modifying institutions to accomplish this objective.

Institutions are composed of formal rules, informal constraints and their enforcement characteristics. Formal rules are constitutions, laws, rules and regulations; informal constraints are made up of conventions, behavioural norms, and self-imposed constraints on conduct. Enforcement is either first person (self-imposed), second person (retaliation) or third person (ranging from peer pressure to governmental enforcement).

"The key to economic performance is to structure human interaction to reward productive activity," said North.

"The essential conditions are the creation of an incentive structure that rewards productive activity and discourage anti-social behaviour in the specific setting of impersonal markets, both political and economic," noted North.

At present, reforms and development in China's financial markets have been largely constrained by lack of a basic system that can effectively document and supervise personal, corporate and governmental credibility.

Though the authorities try to introduce modern corporate governance to enhance the financial sectors' risk control, frequently exposed financial fraud indicates that a much broader transformation involving laws and rules that define the behaviour of other market players is urgently needed.

Evolving structures

Just as North pointed out, "an additional dilemma is that we are evolving political/economic/social structures that are radically different and more complex than any in our past. Therefore, the evolving human environment has no historical precedent from which to derive theoretical inspiration."

In other words, one country must find its own way to establish a flexible institutional structure that encourages the kind of trial and error structure as an essential prerequisite for survival in a world of ubiquitous uncertainty.

With drastic changes in technology, information costs and relative prices, China has rammed through a range of bold and painful economic reforms that pave the way for its rise as a new growth engine of the world economy.

Sometimes the changes may seem slow and subtle, but their significance is huge. And their implication is critical for China to sustain its long-term growth story.

Nevertheless, when tackling emerging problems, policy-makers are apt to confuse public good with some vested interests.

For instance, during the course of anti-monopoly legislation, some government departments display an unwarranted favourtism for some domestic industries or enterprises against foreign competitors.

In the economy it is competition that turns the interests of the individual producer into a social "good," argues North.

But what kind of competition? It must be competition that gets the players to compete via price and quality rather than other socially undesirable behaviours, said the US economist.

Breaking monopolies

The reason the government should break monopolies, he believes, is competition among large high-tech business firms, which will ensure continued innovative activity and, very plausibly, their growth because they take innovation as a prime competitive weapon.

Ever since China adopted reform and opening-up policies in late 1970s, going high-tech has become a shared dream of domestic enterprises and the policy-makers. Innovation has thus been advocated to achieve this goal.

But few have recognized innovation as a decisive competitive edge.

Why? A major reason is that China had been slow in putting in place a sound intellectual property rights protection system.

North noted that changes in structure of the US intellectual property system in the 20th century, as well as the treatment of intellectual property by the judiciary, thus enhanced firms' incentives to both internalize industrial research and to invest in the acquisition of technologies from external sources.

Institutional innovation

The robust growth of the US high-tech industries in recent years bears full testimony to the vital importance of a broad institutional framework to encourage innovation.

China must speed up all-round innovation if it wants to shift from previous extensive growth at the expense of resources and environment to more efficient sustainable development.

But before innovation can take root in this country, policy-makers should do away with institutional obstacles in various forms.

(China Daily)

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