After the Fall of Communism, Why Did Russia Become Democratic and China Remain a Communist State?

A friend emailed me the other day asking for my thoughts on why Russia democratized after the fall of Communism and China did not. My initial, flippant thought is, Russia democratized? But that's too harsh. Let's give Russia the benefit of the doubt that it is a representative democracy, or a republic. Let's also give China the benefit of the doubt and not say "the fall of communism," but instead the beginning of the adoption of market economies. I think there are three factors for why Russia has democratized since the fall of the Soviet Union, and why China has not democratized since the fall of the Gang of Four and the rise of Deng Xiaoping Theory: 1) different solutions to the trilemma of international finance; 2) historical tradition; and 3) the particular circumstances in each country that led to the adoption of market economies.

Trilemma of International Finance

What is the trilemma? The New York Times had a great article by Gregory Mankiw on the trilemma almost two months ago. The trilemma is that economic policy makers would like to achieve the following three goals, but economic logic only allows regulators to choose two of the three:

1. International capital mobility;
2. Ability to use monetary policy to stabilize the economy; and
3. Maintain currency stability.

Although some argue that the trilemma can be challenged, research tends to show that it does indeed exist.

The US has chosen the first two 1) by allowing Americans to easily invest abroad and by allowing foreigners to easily invest in America, and 2) by using the Federal Reserve to set monetary policy. 3) But at the price of a volatile dollar value which is set by international markets.

Europe has chosen the first and third 1) by allowing Europeans to easily invest abroad and by allowing foreigners to easily invest in Europe, and 3) by maintaining currency stability, at least across the euro zone. 2) But at the cost of nations giving up the ability to use monetary policy to the European Central Bank.

China has chosen the second and third 2) by setting monetary policy, and 3) by maintaining tight control over the exchange rate of the yuan. 1) But at the cost of restricting outbound and inbound international capital mobility to control how much money comes into and goes out of the country.

Russia's policy is closest to the US in practice. 1) There are some restrictions on international capital mobility, but a) they are not as strict as China's, and b) the geographic realities of China and Russia make them more difficult to enforce in Russia's case. 2) and 3) The goal of the Central Bank of Russia is to maintain currency stability, but it has proven ineffective at maintaining currency stability, and is instead focusing on using monetary policy to stabilize the economy (see the link to the "goal of the Central . . .").

When economic policy makers choose to restrict international capital mobility, I think that it necessitates a government with stronger or more authoritarian control over its citizens. And I think a democratically elected government would have a much harder time maintaining legitimacy with such tight controls on capital mobility. That isn't to say that China's economic policy isn't working brilliantly, just that democracy suggests greater freedom, and capital mobility restrictions are a more tangible restriction on freedom than currency pegging and a central bank's tinkering with monetary policy.

Historical Tradition

We all know the traditional narrative about government institutions in the West v. those in the East, right?

The historical tradition in the West follows an embrace of an idealized Athens and Rome. Athens became super-rich as the de facto head of the Delian League, and being rich is totally awesome because you have all this cash to make art and pay for plays. People even forget that everybody got pissed at you for being super-rich, and you got your ass handed to you by Spartans in the Peloponnesian War, and twice more by barbarians: one Macedonian, and the other Roman. Rome was super-powerful, and being powerful is awesome because it allows you to dominate others. To be super-rich and super-powerful, the Western tradition dictates that you should be like Rome and/or Athens, and to be like Rome/Athens, we look to their writers. Democracy, or at least a republic, where citizens exercise votes to choose their leaders is considered ideal because Plato wrote about Socrates arguing about topics such as courage, liberty and freedom. But Plato actually believed in philosopher-kings, and when western philosophers started reading all of the awesome Aristotle during the Renaissance that Islamic and Jewish scholars had preserved, they started to totally dig this idea of a real republic which resulted in liberty and freedom, not that fake one that Plato writes about. Then a bunch of well-educated people bought a bunch of printing-presses and had some revolutions. Some were cool, some were creepy, and tradition is preserved.

In the East, Qin Shi Huang unified China through a highly bureaucratic state in which the nobility was replaced by a relatively meritocratic hierarchy of officials who administered the state which begat a major ass-kicking of the other kingdoms during the Warring States period. After Liu Bang successfully exploited Qin and Chu weaknesses, the Han dynasty emulated Qin's bureaucracy. Fast-forward through a couple thousand years of monarchical bureaucracies to the People's Republic China, and what China now has is a single-party, nominal republic with a highly bureaucratic state. Tradition is preserved, but the monarchy has, if you'll allow me some wiggle room, been replaced by the Party.

But what of Russia, that great nation that straddles East and West? As anyone who has ever read Tolstoy's War and Peace can tell you, a) it's long, and b) 19th century Russians really dug French culture. We see Russia's fascination with and eagerness to engage with Europe over the arc of it's history, particularly manifested in 1) the declaration of Moscow as the New Rome under Ivan the Great following the Ottoman conquest of Byzantium in 1453, 2) the military, political and economic reforms of Ivan the Terrible, and 3) a turbulent affair with a pair of Germans. Russia aspired to be a part of the West, and democratic institutions are more in line with the historical traditions of the West, which Russia has engaged with for far longer than the east, than a single-party bureaucracy.

Circumstances at the Inception of the Adoption Market Economies

This, I think, is the big one. Fortunately, I think I can describe it less verbosely than the other two.

The collapse of the Soviet Union began with turmoil in the Warsaw Pact allies. The communist countries of Eastern Europe were economically inefficient as a direct result of the command economy. The governments had lost legitimacy because of the form of government. After the Sinatra Doctrine, the Eastern European countries turned to new forms of government that were modeled on representative democracies. When economic inefficiencies finally brought down the Soviet Union in 1991, it was also because the form of government was blamed for the economic inefficiencies. With the form of a highly centralized and all-powerful federal government rendered illegitimate, a new form of government was needed, and because of tradition and the First World's success with representative democracies, the Second World decided to take the democratic route. Of course, this probably could not have been accomplished without the strong personalities of Gorbachev and Yeltsin.

The adoption of a market economy in China began in 1978 when Deng Xiaoping became head of the CPC and guided the Party toward political and economic pragmatism. But it was never the Party or the autocratic government that had lost legitimacy; it was people in the government that had lost legitimacy. Mao Zedong's policy of perpetual revolution had caused the country to economically stagnate, and atrocities were committed under the Gang of Four, but people still believed in Communism, and Deng Xiaoping brought China a socialism with Chinese characteristics: "Poverty is not socialism. To be rich is glorious."

China had not been a world superpower on the order of the Soviet Union post-WWII and prior to the adoption of market reforms. There was not glorious scientific, athletic, and artistic achievement in China in the post-WWII to Deng period. Communism was not associated with poverty, poverty simply existed, and Deng started to bring China wealth under the auspices of Communism. The CPC has not been without its hiccups since 1978, but it has been remarkably successful at maintaining control and legitimacy.

Posts of the Week: 8/23/10 - 8/29/10

Chinese Banks Are Making Easy Profits Off of Artificially Low Interest Rates at Money Game

Reports of China IP’s Demise Are a Bit Premature at China Hearsay

Manufacturing: Maybe It Isn't China at Free Exchange
Since the end of World War 2, US manufacturing output has grow steadily and manufacturing employment has declined steadily. Getting tough on China will not reverse this trend.

Have We Underestimated Chinese Consumption at China Financial Markets

China Needs 10 New Yorks Over the Next 20 Years. How Do We Get in the Real Estate Game?

Dan Harris at China Law Blog has been quite bullish on the China healthcare business prospects, particularly pharmaceuticals (see parts one and two). I am not one to disagree, and Chinese pharmaceutical R&D, manufacture, and sales does sound like quite the opportunity. But what if you are not in the enviable position of owning valuable pharma IP? I'd take a wager on construction.

The other day it was revealed that Blackstone was reentering China's real estate market. I was a bit shocked by this news, as I'm sure many others were, because all the signs seem to be pointing towards a real estate bubble in China: 25-30% of commercial and housing space may be sitting vacant, prices seem to be leveling off, and the government has apparently insisted on tightened real estate lending. Intrigued, I delved further and realized that Blackstone was actually investing in a realty developer. Now that makes sense!

A recent piece at Foreign Policy heralds the coming of the Megacities through a collection of charts and graphs of urban changes in China and India over the coming 20 years. Of particular note is that China will require 40 billion square meters of new commercial and residential space over the next 20 years. That is equivalent to 10 New Yorks, or the size of Switzerland. A rising tide might not necessarily lift all boats, but it will surely lift those with the capital necessary to keep building. And a company like Blackstone should be able to provide the financing to a housing developer to ensure that it can reap a healthy profit off of the natural growth of China's urban landscape.

So how does one go about getting into the construction game? Well, construction of anything worthy of a significant foreign investment, such as 1) class A hotels, residential buildings or office buildings, 2) international exhibition centers, 3) large scale theme parks, 4) public gas, heat, water facilities, 5) golf courses, 6) cinemas, 7) refineries, and 8) smaller coal fired plants, falls in the Catalogue of Restricted Foreign Investments. This does not mean that it cannot be done, it just means that the formation of a company that wants to engage in one or more of these types of construction will be subject to a more onerous (read: more lengthy and expensive) review and approval process than other types of foreign investment. This, of course, is in addition to the standard examination and approval procedures (see a "simplified" flow chart). But if you have the time, money and patience, plus some synergies in your portfolio, construction sounds like one hell of an opportunity.

The Huawei and Sprint Nextel Deal Seems Innocent Enough

On first impression, the eight Republican Senator's opposition to Huawei's bid to supply Sprint Nextel with telecommunications equipment in the US seemed like a typical political exploitation of xenophobia, particularly in a competitive mid-term election season. But Huawei has had some accusations against them over the years that make them seem more suspect than other Chinese companies. However, I think the nature of this particular business deal does not make it a serious security risk.

Huawei was accused of stealing technology from Cisco, Motorola, and some vendors at a Supercomm show. Cisco's suit against Huawei was dismissed because it was determined that rogue developers were at fault, the 'spy' at the Supercomm show was never prosecuted, and we have yet to see whether the Motorola case has legs. So Huawei's history with corporate espionage is so far undetermined.

Transactions with Huawei have previously run into problems in two other countries. In the US, Huawei was attempting a merger of 3Com and the CFIUS committee found that the merger would pose a threat to national security, but the deal was not blocked. Instead, Huawei voluntarily withdrew their offer. The Indian government has also previously canceled two deals between Huawei and Indian telecom companies because of national security concerns, including BSNL and Sistema Shyam Teleservices Ltd., the Indian unit of Russia's AFK Sistema.

The allegations of corporate espionage have not yet proven true, and while corporate espionage is a criminal issue, the government should not block a deal because it is possible that Huawei might steal technology from Sprint. Sprint should be able to make those determinations on their own as part of their willingness to be supplied by Huawei.

Even if there have been security concerns in the US over a merger with Huawei, those same concerns should not be a problem in the supply of equipment in the US market. The great and only fear, of course, is a hardware hack. The successful application of hardware hacks in espionage is limited, and largely just to the US against very specific targets that were already our enemies.

A hardware hack is an unreasonable fear, the risk of technology theft can be dealt with effectively by Sprint's choice to deal or not deal with Huawei, and it's time to realize that the second largest mobile equipment in the world, Huawei, might, might just be after a profit. And if they're the best provider of equipment, then it's a net good if Sprint buys their equipment from Huawei.

Richard Pozen's Solution to Solve the US-China Trade Deficit

Robert Pozen wrote an op-ed for the WSJ yesterday arguing that the best way to shrink the trade deficit is for Chinese companies to increase wages, rather than faster yuan appreciation: Bashing Beijing Will Not Help Our Trade Deficit. He argues this because wages are the most expensive input for most of the goods exported from China to the US. And if wages increase, then Chinese will have more money to spend in China resulting in more of China's goods being purchased in China.

He also attacks yuan appreciation as an effective tool for the 3 following reasons:

1. Exports from China to the US are assembled in China while the component manufacture takes place in other countries. Chinese input costs are typically about 10%, so even a substantial appreciation would not result in a large increase in prices.
2. Appreciation of the yuan would push low-end manufacturing to other countries, but the overall exports to the US would be the same, just not from China.
3. The volume of high-end exports to the US is driven by competition with Germany and Japan, which depends more on the value of the euro and yen.

There are some significant problems with Mr. Pozen's argument.

First, if Chinese input costs are not significant, then higher wages will have no different effect on the trade deficit than a more valuable yuan.

Second, wage increases would also result in low-end manufacturing migrating to other countries. Also, many of the products manufactured in China for the US market are never sold in China. If wages increase, then Chinese might have more money to spend on the goods, but the goods would not be sold in the Chinese market anyway. The overall US trade deficit would remain the same, and jobs would likely be lost in China because the goods currently being manufactured for the US market cannot likely be re-purposed for the Chinese market.

Third, if the volume of high-end exports from China is driven by competition with Germany and Japan, and the value of the euro and yen is a strong factor in determining which country customers purchase goods from, then surely the value of the yuan would also be a strong factor if it appreciated to its true value due on freely convertible exchange.

Lastly, and most importantly, either a wage increase or an increase in the value of the yuan would produce the same end, but it is impossible to use a stick to force Beijing to raise the minimum wage in China. It is possible and legal to use sanctions against a country if they are manipulating their currency. That is not to say that China is manipulating their currency under the law, but the yuan is certainly undervalued.

Mr. Pozen's real concern is that American politicians' declarations that China is a currency manipulator only provoke resistance, and that they should instead promote higher wages. I certainly agree that yelling in front of cameras that China is a currency manipulator is not the most effective method to get China to act, and I wish Mr. Pozen had restricted his argument to this point because telling China that their workers don't earn enough certainly can't be any more effective.

However, hasn't Washington been fairly effective at getting Beijing to loosen up its currency Policy? It reminds me of the classic and instructive South Park episode when Cartman travels back to 1776 and learns Benjamin Franklin's important policy that a republic can have its cake and eat it too by voting to go to war while being anti-war. In this case, Senator Chuck Schumer and legislative branch can play bad cop, while Timothy Geithner and the executive branch play good cop, and concessions are reached.