A greater role for government?

'Animal spirits' with Chinese characteristics By Mark A DeWeaver

In one of the twentieth century's most influential books, The General Theory of Employment, Interest, and Money, British economist John Maynard Keynes argued that investor decision-making is often influenced more by "the mass psychology of the market" and "animal spirits" than by rationally formed expectations of future returns. This led him to conclude that "the duty of ordering the current volume of investment cannot safely be left in private hands." Instead, he called for a greater role for government policy in guiding capital allocation decisions on the grounds that this would greatly reduce investment volatility and thus help to eliminate boom-bust economic cycles.

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China's economic reforms since 1978 have done away with many of the features of the old centrally planned economy, but investment continues to be highly volatile. While the introduction of asset markets has created new speculative distortions, the old policy cycle continues to operate as well. When policy is loose, overinvestment is encouraged by local officials, whose decisions are influenced by opportunities for promotion, competition for tax revenue, or even bribery. At the same time, the ability of managers to siphon off profits while leaving the state to bear losses encourages excessive risk-taking. Later, when policy is tightened, local government activities and enterprise-financing come under increased scrutiny by the central government and boom turns to bust.

DeWeaver presents these possible causes:

• desire for promotion plays a big part: cadres tend to be rewarded for economic growth in their areas
• competition for tax revenues
• bribes from contractors
• kickbacks from suppliers
• corruption in financing overinvestment: managers are frequently in a position to use bank funds for private businesses
• situations in which "the manager is responsible for profits, while the state is responsible for losses"

DeWeaver concludes:

Contrary to what Keynes believed, in China state control of investment has not only failed to tame the "animal spirits" of the free market but is actually a source of additional instability. During the command economy period, leaving the "duty of ordering the current volume of investment" in the hands of the central government produced some of the worst economic disasters on record. Subsequently, it has also become clear that this duty cannot safely be left in the hands of local government officials given the perverse nature of their incentive structures. And while speculative investment using one's own money must at some point be limited by fear of loss, for someone in a position to misappropriate state funds with impunity, the optimal "volume of investment" is practically infinite.