Prescott: Free trade is key to China's economic potential

China's economy has made huge strides since Deng Xiaoping commenced market reforms in 1979. Edward C. Prescott, the 2004 Nobel Prize laureate in economics and professor at the W. P. Carey School of Business, estimates that China's standard of living now stands at about one-seventh the level of the world's leaders. Beijing authorities are eager to narrow the gap further between China and advanced industrialized countries. Prescott believes the answer is not to be found in conventional economic theories on trade volumes or comparative advantage. He argues that China needs to cast off constraints on supply — and that promoting free trade will play an essential role in the process.

The release of the latest Star Wars film, Episode III: Revenge of the Sith, says a lot about the challenges in store for China's economy.

Within days of the movie's theater debut, roving vendors in Beijing were selling pirated DVDs out of their bicycle baskets for a mere $1.20. The U.S. movie lobby, apoplectic over the latest episode of counterfeiting, threatened to take their complaint to the World Trade Organization.

But it's not just the DVD ripoffs that have the movie executives steamed. The bigger problem, they say, is that China only allows 20 foreign films to be shown in the country each year on a revenue-sharing basis. By limiting supply, authorities effectively hand over the market to black market profiteers. No one can say how soon China will open up its film market, but the answer will reveal much about the government's willingness to further liberalize its economy. And that, in turn, offers clues to whether China can sustain its breakneck economic growth.

Narrowing the gap

On the development front, of course, China has made huge strides since Deng Xiaoping commenced market reforms in 1979. Edward C. Prescott, the 2004 Nobel Prize laureate in economics and professor at the W. P. Carey School of Business, who spoke at the Sino U.S. New Market Economy Forum in Beijing in June, estimates that China's standard of living now stands at about one-seventh the level of the world's leaders, measured on a per capita purchasing power parity basis. But Beijing authorities are eager to narrow the gap further between China and advanced industrialized countries. So what's the best way for China to fa cai — get rich?

Prescott, whose research seeks to explain why some countries are richer than others, believes the answer is not to be found in conventional economic theories on trade volumes or comparative advantage. He argues that China needs to cast off constraints on supply — and that promoting free trade will play an essential role in the process.

China's own economic history highlights the benefits of free trade, points out Prescott. In the Song dynasty (960-1279), China was twice as rich as the rest of the world. But when the nation later turned inward in the Ming Dynasty (1368-1644), cutting off trade and cultural links with other countries, technological progress lagged.

China's experience highlights a lesson for all developing countries: open economies are conduits for wealth, says Prescott. His theories about comparative international growth, developed with fellow economist Stephen Parente of the University of Illinois, focus on the role of supply-side efficiency. According to Prescott, a given country's productivity level depends not only on its store of knowledge, but also on the existence (or absence) of production constraints that weigh down efficiency.

These constraints may range from seemingly discrete problems, such as company cultures that permit pervasive bribery, to more systemic weaknesses, such as regulations that make it difficult to start up a new business. In the latter vein, Prescott says he was influenced by fellow economist Hernando de Soto, who found that it took a year and a half to start up a small garment business in Peru. In New York City, a would-be clothing magnate could accomplish the same thing in a single afternoon. The difference helped explain why a culture of entrepreneurialism had failed to take hold in Peru.

Free trade vs. political meddling

So why do such burdensome constraints exist? Prescott's research has found that they often serve to protect industry insiders with vested interests. In theory, production should be oriented with an eye towards maximum efficiency, but in real life, economic ideals may take a back seat to politics.

Politicians, faced with the specter of large-scale layoffs in their home districts, often feel obliged to intervene and try to persuade (or bully) companies into maintaining the status quo. The chain of events follows a predictable course, says Prescott: "The adoption of more efficient production reduces employment; people in that industry get upset; they bring maximum political pressure to bear; and they often succeed in getting sympathy from other groups."

He argues that such interventions are ultimately counterproductive, merely delaying the adoption of more efficient production techniques that would make everyone richer.

In practice, poor countries tend to have many workers stuck in low-level service jobs, earning their living as gas station attendants or elevator operators. A selected group of people gains from being guaranteed a minimum level of income and stability. But there's a broader loss of economic efficiency, because resources are being allocated on the basis of politics rather than the market. Over time, argues Prescott, countries that follow this model will fall behind their counterparts.

The great advantage of free trade, he says, is that is helps liberate economies from unhelpful political meddling.

To that end, Prescott defines a free trade club as a set of states whose members aren't allowed to impose tariffs on each other or restrict each other's imports. Also key: each state respects the property rights of other member states. In other words, if a U.S. company chooses to locate a factory in Mexico, it feels secure in knowing that its assets won't be appropriated by Mexican authorities.

Prescott says both supply-side differences and trade policies help explain the vast economic disparities that have characterized the global economy since the Industrial Revolution. In fact, such disparities — and the corresponding notion that some countries are "developed" while others are not — are a relatively new phenomenon. Throughout most of history, he notes, living standards were similar in countries all over the world. For thousands of years, land was the key unit of production. Given limits on food supply, a trade-off existed between the size of a population and living standards. In other words, if a population increased too quickly, food might run scarce.

Industrial Age a turning point

But starting around 1700, standards in some Western economies commenced a sustained rise, and after 1850, living standards in industrialized nations began doubling every 35 years. Fossil fuels replaced land as the primary energy source. For the first time in history, populations could increase in size without risking a decline in living standards. By about 1900, well into the Industrial Age, vast disparities had developed between European countries and their colonies in Asia and Africa.

At the same time, differences in wealth became apparent among more affluent nations — a development Prescott attributes in part to their respective trade policies.

Case in point: the U.K. claimed the highest living standard in the world up until the turn of the 20th century, but then the U.S. took the lead. Relative to the U.K., U.S. per capita income jumped from two thirds in 1865 to 100 percent in 1900. By 1928, American income per head was nearly 1.4 times that of Great Britain.

Prescott's explanation: "The U.S. was by then a free trade club." Transport costs in the U.S. plunged amid a period of heightened competition between waterways and the newly-developing system of railroads. As easier transport paved the way for increased commerce, he says, "The U.S. became an economically integrated set of sovereign states."

Around the same time, sweeping changes were taking place outside Western Europe and the United States. Japan, which Admiral Perry opened to the West in 1870, began a period of modern economic growth that would accelerate dramatically in the postwar era, after which Japan essentially caught up with world leaders.

Latin America, too, saw its economic momentum take off starting around 1870. But its relative living standard has remained stubbornly unchanged since then, stuck at one-quarter the level of rich countries. The cause of its sluggish performance, according to Prescott: "It's not a free trade club. If it became one," he says, "it would catch up."

Making up for lost time

Those Latin American nations that have been most receptive to free trade have been among the fastest growers, he added. Chile, which has forged close economic ties with Western Europe and Japan, is one of the most prosperous and stable countries in the region.

In Mexico, Prescott believes the North American Free Trade Agreement (NAFTA) has had the effect of strengthening domestic banks and retailers, which have been forced to become more efficient to compete with foreign rivals. Largely due to NAFTA, which has increased economic integration between Mexico and its U.S. and Canadian neighbors, Prescott says he's "very optimistic" about Mexico's prospects for growth.

Along the same lines, he says it bodes well that Asian nations are becoming integrated with advanced industrial economies. Distracted by independence movements and wrenching civil wars, many countries in Asia — including China — got a late start in industrializing.

Their standards of living relative to the rest of the world fell until around 1950. Since then, however, they have speedily made up for lost time. Indeed, measured by standards of living, Asian countries have already caught up to Latin American nations that began industrializing almost a hundred years earlier. As for China, the central government's decision in the late 1970s to decentralize the economy, delegating greater authority to the provinces, was an auspicious move. Prescott calls it a "step in the direction of a trading club."

"The huge increase in the size of the market sector run by entrepreneurs is a very healthy signal," he says. The difficulty in predicting China's growth prospects, he adds, is that its government, which has sought to carefully guide growth, will play an outsized role in setting policies. Economists "are not very good at predicting the future of the political process," says Prescott.

There's no way of knowing how quickly China's leaders will loosen their hold on the economy. But until it does, expect Beijing's pirate DVD vendors to keep up a roaring trade.