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The problem with state capitalism

By Ujwal Batra

India is not a capitalist country. The necessary condition for capitalism is the private ownership of property and means of production—all other requirements either stem from that one condition, or are corollaries of it. India does have a system of private property rights but it is significantly circumscribed. For a great majority of Indians, these rights are neither well-defined nor properly enforced; and there exist many laws and regulations which prevent the free employment of property.

India is not a socialist country either. The necessary condition for socialism is outright ownership by the state of all means of production. In that sense, India has never been socialist; though a particular version of Nehruvian-Fabian socialism has dominated our policies and discourse since independence.

The economic system that governs India is a particular variant of ‘State Capitalism’—a system in which the state has a considerable say in economic matters—by partaking in economic activities itself (running public sector enterprises), and by a system of regulatory controls and policies which have a significant bearing on the economic activities of the people.

capitalism-boundState capitalism has its adherents. People cite the rise of China and South Korea in the last few decades as definitive empirical evidence of the virtues of state capitalism. It remains a point of contention whether it was the freeing-up of the economy that contributed to the rise of these nations or the fact that much of the economy was state directed, i.e. whether it was the ‘state’ or the ‘capitalism’ part of state capitalism that led these economies to develop. The Noble Prize winning economist Ronald Coase (along with co-author Ning Wang) makes the case in his book How China became Capitalist, that China grew not because of, but despite state intervention and direction of economy. (For a brief account of this argument, read China: Yes, It’s Capitalism on The Freeman).

But if it was state-led development (or state capitalism) that was responsible for China’s growth; it was state-led development that led to India’s unrelenting economic woes before the partial opening up of India’s economy.

We have then, two visions of capitalism. One is free-market capitalism, in which the state is restricted in its scope to merely protecting the property and rights of people, enforcing contracts and creating a regulatory regime conducive to economic freedom and the generation of wealth. The other is state capitalism; in which the state is an active participant in economic matters.

In considering state capitalism and the proper role of government in the economy; there are a few things that merit our consideration, which ought to makes us skeptical of this system—

How would the state know where to commit its resources? And how can we be certain that this employment of resources would be optimum or ideal? The market works through a process of trial and error. If businesses commit their resources in particular sectors, they do so in anticipation of consumer demand. If they fail to correctly identify or satisfy that demand—they run into losses. The businesses that satisfy consumers survive; the ones which fail to do so either adapt (by diverting resources in more productive channels) or run out of business.

imagesState businesses are not subject to the same rigor as private businesses are. The state may well decide that a particular industry ‘serves the public good’ despite it not being profitable; and continue to pump it with money and resources. Not only are state enterprises shielded by special laws and favors; they can also resort to the use of taxpayers’ money if they run into losses. B R Shenoy elaborates on this point brilliantly in his article on State Planning and Social Justice written in 1961. He remarks that as the investment decisions were taken by the state and not driven or guided by consumer demand; they were woefully inadequate in serving the needs of the people. There was large investment in heavy industries, many of which lay idle and were not responsive to the immediate consumption needs of the people.  The state’s channeling of resources “neither filled empty stomachs nor covered naked shoulders”.

Businesses need to be guided by, and be responsive to consumers; not the judgments of planners. State capitalism is neither driven by, nor subject to the constraints of economic efficiency; and therefore, there is no guarantee that the outcomes it yields would be economically optimal.

The same problems that are present with the state running businesses are present with the state dictating economic policy. State running businesses can lead to a misallocation of resources. Similarly, a bad policy and regulatory framework can create a set of incentives which can lead to a channeling of resources to outlets that are less than ideal. Consider the far-ranging impact of state economic policy. A stifling set of labor laws would prevent the free movement and employment of labor. The state policy on credit—say, giving cheap credit to particular businesses or industries would make these businesses survive artificially, whether or not their products are desired by the people. Likewise, any state economic policy decision would have far reaching consequences; and would result in an employment of resources very different from one that would have occurred in the absence of a preferential policy framework.

This is not to say that the state has no business in policy—the point is that the state’s role in framing laws and policy should be restricted to creating a level-playing field—the only driver of the resources being consumer demand and preferences.

There is a further consideration as we consider state capitalism—the kind of institutions it rests on and promotes. Daron Acemoglu and James A Robinson remark that the real dichotomy is not between state capitalism and free-market capitalism; it is between “extractive and inclusive economic institutions”. 

 “But herein lies the problem for state capitalism: inclusive institutions require a private sector powerful enough to counterbalance and check the state. Thus, state ownership tends naturally to remove one of the key pillars of an inclusive society. It should be no surprise that state capitalism is almost always associated with authoritarian regimes and extractive political institutions.”

State capitalism ultimately rests on institutions that restrict our freedom; particularly our economic freedom—the freedom to produce and exchange in any matter we see fit. Its outcomes are not driven by considerations of economic efficiency; and its outcomes are far from just.

 This article originally appeared on Spontaneous Order.

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