Path Dependence in Endogenous Institutional Change

The decline of the old economy in post-Mao China did not follow the path of the former Soviet bloc, where bottom-up revolutions created new political regimes that subsequently imposed top-down programs of “shock therapy” for a drastic transformation of economic institutions. Yet there have been several pivotal events in the Chinese case that generated significant changes in the parameter of decision-making for political and economic actors. Among the events that are most relevant for understanding the process of privatization are the CCP’s decisions to initiate fiscal restructuring in 1977, to shift the focus of policy from class struggle to economic development in 1978, to open up the economy for foreign trade and investment in 1979, to decollectivize agriculture and legalize self-employment in 1980, to remove the size limit on private business in 1988, to restructure the fiscal and banking systems in 1994, and to carry out ownership restructuring of SOEs in 1997 (chapter 1). With the exception of the timing of the historic move to depart from Maoism in 1978,[1] all the other events were driven by endogenously derived forces. I have argued and shown that a major driving force leading to these events stemmed both from the efforts of the party-state to introduce new ways to fix the deficiencies carried over from the Maoist system and from those to cope with the problems and challenges arising from post-Mao ameliorating measures for addressing the policy imperatives of revenue and employment. The path of institutional change in this process of cumulative causation, involving decisions, actions, and interactions at and between central and local levels, is subject to the influence of the self-interest calculus of political actors in face of an evolving structure of incentives and constraints and the feedback from their earlier behavior and responses conditioned by the long-lasting impact of demographic forces and the preexisting fiscal system.

As noted above, the initial strategy of the central leadership to rely on public enterprises to play the leading role in marketization and internationalization was sustained for over a decade despite growing moral hazard, and the failure to contain opportunism eventually led to the demise of the vast majority of public enterprises. Cognitive constraints, such as bounded rationality (Simon 1957; Lindblom 1959), could have been a reason for such failure, especially given the adaptive and problem-driven nature of the reform process (Naughton 1995; Perkins 1994). Political expediency and compromises among different interest groups in the leadership might be another reason (Fewsmith 2008; Shih 2008), as CCP leaders wrestled and coped with circumstances by taking a path of least resistance, instead of an all-around approach, in designing reform measures. Also relevant is the fact that there were competing considerations in personnel policy that led to transient tenures and lack of clarity in cost accounting for political responsibility in local public administration, as discussed in chapter 4. An even more powerful contributing factor revealed in this book is the positive feedback that the initial strategy generated.

To political actors at all levels, the strategy of promoting marketization through public enterprises looked like a win-win solution and thereby developed a self-reinforcing mechanism. Accounting for this mechanism entails an understanding of how the fiscal system evolved. In particular, it was a key feature inherited from the old system that induced the opportunistic behavior of local officials. That is, government revenue was heavily reliant on sales-related taxes. Efforts of subordinate levels to promote sales growth through the public enterprises under their purview, often without regard for profitability and fundamental financial health, helped boost both revenue and employment in the short run, which served both their self-interest and their superior levels’ interests but undermined the sustainability of these enterprises.

As this perverse positive feedback loop progressed, it eroded the organizational foundations of public ownership and effectively “locked out” the longer-term survivability of most of its carriers. In the meantime, the growth of private economic activities under rules bent by local officials in regions experiencing early privatization generated and reinforced a different type of positive feedback—economic and political interests that helped “lock in” the prospect of private ownership as an increasingly viable alternative for addressing the key concerns for regime survival. Explaining the uneven paces of early privatization, though, requires an understanding of the varying initial conditions shaped by the recent histories of different locales, especially those concerning the strength of local public industries, the stock and vitality of local entrepreneurial forces, and the interdependence between superior and subordinate levels. As I have shown in chapters 4-6 these factors had a direct bearing on the strategies and outcomes of interaction between political and economic actors and between different levels of political authority.

The interplay between the “lock-out” and “lock-in” effects of positive feedback illustrates an important mechanism of evolutionary institutional change. The latter does not work independently of the former, but rather moves in tandem with it along convergent paths. The growing role of entrepreneurship in China’s privatization, for example, cannot be fully understood by only looking at the strategies and perseverance of economic actors and without a close examination of how and why the public sector self-destructed and locked itself into a dead end under the purview of political actors. The rise and decline of the new and initially dominant institutional order in the Chinese case also suggest a need to broaden the contingency view in the literature on path dependence, which focuses on self-reinforcement (and hence a “locked-in” path) of a positive feedback loop driven by realigned political and economic interests in an initially fluid state, often rendered by exogenous shock(s), of institutional order (e.g., Mahoney 2000; Pierson 2004). Central in this broader view are the forces that affect institutional (in)stability, which in turn are subject to the long-lasting impact of past and continuing institutions and structural forces such as demographics and political and economic interests associated with the fiscal infrastructure of the state.

Furthermore, such impact is relevant for understanding not only the supersession of newly emerging institutional orders but its tempo and spatial spread. I have shown that the forces developed in the cumulative causation process of ownership change not only triggered the CCP’s pivotal decision to restructure SOEs in 1997 but accounted for the subsequently precipitous decline of public ownership and pushed it beyond the initial limit prescribed by that decision (chapter 7). The political bandwagon effect driven by the pent-up reactions of “laggard” locales (in both public sector-led growth and early privatization) and by regional peer influence, the shift of local officials’ policy focus from industrial development to urbanization, and the growth of opportunities for asset stripping and insider control before and during ownership restructuring, all contributed to the drastic transformation of China’s economic landscape around the turn of the century and the legitimation of private ownership as a necessary evil. They all, too, embody the consequences of past decisions and responses of political and economic actors, including those of successive CCP leaders. Like countless rulers in history, these leaders have had to drift with the tide of their own making, rather than navigating against it, in order to survive. In so doing, however, they have increasingly lost control over the destiny of the party-state, as well as that of the economy and society.

  • [1] Two “shock” factors—i .e., Mao’s death in 1976 and massive natural disasters in 1977-78—wereamong the forces that triggered the decision on reforms in the pivotal meeting (the Third Plenum ofthe Eleventh Central Party Committee) of the CCP leadership at the end of 1978. See Lin 2003 for adiscussion of how the causal mechanisms played out.
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