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1.2 RESOURCE MISALLOCATION AND POTENTIAL STAGFLATION IN THE SOCIALIST ECONOMY

1.2.1 The Cause of Stagnation and Inflation in the Socialist Economy

Stagnation refers to economic slowdown, which is characterized by lowering economic growth with growth rate hovering at a low level. Inflation refers to higher price level, characterized by rising prices. Stagflation refers to the phenomenon where stagnation and inflation exist simultaneously.

Stagnation and inflation may occur one at a time or at the same time in the socialist economy, a point I have discussed in Socialist Political Economics . What is the root cause of stagnation, inflation, and stagflation in the socialist economy? Can we simply consider them the fallout from administrative mistakes or some coincidental events? The above analyses on economic disequilibrium and the impact on resource allocation from socialist economic system have revealed the fundamental root causes of stagnation, inflation, or stagflation. Administrative mistakes or coincidental events, even though having certain connections with stagnation, inflation, or stagflation, only make situations worse or are factors that induce them.

Current Chinese economy runs in a state of disequilibrium. Both aggregate imbalance and structural imbalance are probable. The former is demonstrated by a mismatch between aggregate supply and aggregate demand, resulting in either economic slowdown or inflation, while the latter manifests as a mismatch between the demand and supply of key products, causing either economic slowdown or inflation. Thus, stagnation or inflation, due to either aggregate or structural factors, will normally occur separately. If aggregate imbalance and structural imbalance occur simultaneously, there will be four possible scenarios:

1. Stagnation due to aggregate factors and structural factors

2. Inflation due to aggregate factors and structural factors

3. Stagnation due to aggregate factors and inflation due to structural factors

4. Inflation due to aggregate factors and stagnation due to structural factors

Stagnation and inflation occur separately in the first two scenarios and simultaneously in the latter two scenarios, i.e., stagflation. These four scenarios are all probable in a disequilibrium economy. They are relatively easy to understand in the traditional economic system and the dualtrack economic system. If we established the new economic system in the future, could we possibly prevent stagnation, inflation, or stagflation? Not necessarily. As mentioned above, in the new economic system, enterprises will have become goods producers that operate independently and are responsible for their own profits and losses. The market will have become relatively fully developed, if not completely fully. Prices can function normally as signals to adjust demand and supply. However, as long as resource constraints (and possibly demand constraints) persist, the socialist economy in the new economic system will remain a disequilibrium economy or an economy with a relatively low degree of disequilibrium. That being said, stagnation, inflation, or stagflation is still possible.

The above analysis has demonstrated that the root cause of stagnation, inflation, or stagflation in the socialist economy is not the socialist system itself, but aggregate imbalance and structural imbalance during the operation of a disequilibrium economy. Having said that, what is the cause of aggregate imbalance and structural imbalance? To answer this question, we have to look at potential macroeconomic and microeconomic mismatch in an economy.

1.2.2 The Cause of Macroeconomic and Microeconomic Mismatch

There are circumstances in which macroeconomic and microeconomic mismatch occurs, which is not entirely attributable to the traditional socialist economic system or the dual-track economic system. Let us assume that we have established the new economic system, where enterprises and individuals conduct economic activities independently and make their own decisions based on their best economic interests and intentions. This makes it impossible for them to automatically synchronize their activities with the national economy, hence leading to macroeconomic or microeconomic mismatch. More specifically, in the new economic system, enterprises make their own decisions with regard to the level of inventory and borrowings based on their own expectations of price level, interest rate, or supply and demand in the marketplace. So do individuals, who adjust their personal stock of consumer goods, cash holdings, and form of assets in accordance with their own expectations of price level, interest rate, or supply and demand in the marketplace. These activities will impact the demand and supply of both merchandise and capital in the marketplace. We understand from the changes of enterprise and individual behavior that the fluctuations of inventory in the market will cause abnormal inventory in the economy or excessive money in circulation, which will naturally lead to macroeconomic or microeconomic mismatch. Therefore, it is obvious that any macroeconomic or microeconomic mismatch in the socialist economy as well as the resulting aggregate imbalance and structural imbalance(manifested as stagnation, inflation, or stagflation) will not disappear even after the new economic system is established. However, whenever macroeconomic and microeconomic mismatch occurs, the new economic system is more effective in releasing the power inherent in the economy to offset such mismatch than the traditional economic system or the dual-track economic system, and the influences of government's actions to reduce or eliminate such mismatch are also more far-reaching in the new economic system than in the traditional economic system or the dual-track economic system. If we conclude that we will always see macroeconomic and microeconomic mismatch and aggregate and structural imbalances in the form of stagnation, inflation, or stagflation in any type of socialist economic system, the traditional economic system or the dual-track economic system will experience more severe mismatch or imbalance than the new economic system, and the cost to the economy to correct such mismatch will also be much larger. If we can summarize the process of socialist economic activities as one that gradually changes from macroeconomic and microeconomic mismatch to moderate match and then to a new level of macroeconomic and microeconomic mismatch, the traditional economic system and the dual-track economic system, in comparison to the new economic system, will need a longer period of time migrating from macroeconomic and microeconomic mismatch to moderate match, face more obstacles down the road, and pay a higher price. They, however, need a relatively short period of time transiting from moderate macroeconomic and microeconomic match to the new macroeconomic and microeconomic mismatch, which tend to develop fairly quickly.

Now, let us go back to disequilibrium economy. It is clear that if the socialist economy turned out to be in the equilibrium described by Walras, excess supply and demand would not exist and aggregate imbalance or structural imbalance would not occur either. It will be impossible to see macroeconomic and microeconomic mismatch, thus eliminating such phenomena as stagnation, inflation, and stagflation. However, the equilibrium economy that Walras described is not real. Disequilibrium is the reality for any economy. Therefore, we may conclude that any imbalance in the socialist economy or any macroeconomic and microeconomic mismatch is a result of the imbalances of economic activities, not administrative mistakes or coincidental events.

1.2.3 Stagflation and Resource Misallocation

Economic slowdown or inflation in the socialist economy represents resource misallocation. It is easier to understand that economic slowdown, as there are bound to be considerable idle resources during economic slowdown. In terms of the production process, idle resources include excess production capacity, idle labor, as well as raw material overstock. In terms of the circulation process, idle resources result from the sluggish sales of manufactured products and abnormal inventory in the marketplace. Of course, serious shortages of certain key products, such as energy, major raw materials, major equipment, and services by the transportation sector, can also cause economic slowdown, which is also a reflection of resource misallocation. Resource misallocation in this scenario manifests as a distorted industrial structure that throws resource allocation out of balance, causing severe product shortages, eventually causing an economic slowdown.

What is the relationship between inflation and resource misallocation in the socialist economy? Why can we say that inflation reflects resource misallocation in the same way as economic slowdown? We can answer these questions by analyzing three different types of inflation:

1. Inflation due to excessive aggregate demand, commonly known as demand-driven inflation

Excessive demand is either caused by escalating investment or rapidly increasing consumption, or both. The reason why demand exceeds supply by a large extent has something to do with resource misallocation, because the participants of resource allocation (i.e., enterprises, individuals, and government) allocate excessive resources to areas whose needs are not justified. In this case, excessive money in circulation is only a phenomenon. The truth behind it is excessive investment or consumption due to resource misallocation.

2. Inflation due to excessively rising cost, commonly known as costdriven inflation

Excessively rising cost is ultimately determined by excessively rising prices of production factors, which is in turn caused by excessive demand or severe shortages of the supplies of relevant production factors. Severe shortages of the supplies of certain production factors can be attributed to a distorted industrial structure, constraints on the mobility of production factors, or lack of investment by the producers of production factors. After all, they are all associated with resource misallocation.

3. Inflation due to mismatch between the structures of supply and demand, commonly known as structural inflation

This type of inflation can be found with regard to certain key products when supply fails to meet demand. When certain key products experience excessive demand and shortages of supply, prices will jump and money in circulation will rise, giving rise to inflation. The reason why there is excessive demand for or shortage of supply of key products is still linked to resource misallocation and consequential product structure mismatch or industrial structure mismatch.

Therefore, any type of inflation is associated with resource misallocation. We can conclude that economic slowdown, inflation, and stagflation are all reflective of resource misallocation. In our research on the socialist economy, we must realize that stagnation, inflation, and stagflation are all linked to resource misallocation. With this in mind, we must concentrate on exploring methods that can eliminate resource misallocation, and search for effective resource allocation that can prevent stagnation, inflation, or stagflation.

1.2.4 The Possibility and Prevention of Stagflation

When an economy encounters structural imbalance, simply suppressing aggregate demand will cause excessive economic contraction. At the same time, rising price level due to structural imbalance will remain unchecked. As a result, stagflation will likely occur. This is a serious issue that we must face in managing the national economy. We must also note that the possibility of stagflation in the economy does not necessarily mean that it will turn into reality. It will require societal purchasing power to turn the possibility of stagflation into reality. It should be noted that even though structural imbalance likely leads to a higher price level, any rise in price level is also related to societal purchasing power. If purchasing power is not strong enough, it will be difficult for the price of shortage merchandise to rise, in spite of structural imbalance between supply and demand. Therefore, if suppressing aggregate demand (e.g., suppressing infrastructure investment, business spending, or residents' disposable income) still leaves us with relatively strong sequential societal purchasing power, which can in turn drive price level higher, we will have to understand the origin of societal purchasing power.

Can it originate from government spending? In other words, can a portion of government spending be diverted toward purchasing shortage commodities? Generally speaking, the possibility does not exist during an excessively contractive period, as suppressing aggregate demand first and foremost entails reducing government spending.

Can it originate from credit expenditures? In other words, can a portion of credit expenditures be diverted toward purchasing shortage commodities? The probability is normally minimal. Suppressing aggregate demand undoubtedly entails reducing credit expenditures.

Can it originate from exports, remittances from expatriates, spending by foreigners within the country (or tourism revenues), or foreign direct investments? All these revenues are likely to become purchasing power for shortage commodities in the domestic market. Suppressing domestic aggregate demand can proceed simultaneously with increasing exports, expatriates' remittances, tourism revenues, and foreign direct investments. Under such circumstance, however, we can prevent price level from rising, in spite of increasing domestic demand for shortage commodities, as long as rising foreign exchange revenues are appropriately utilized to increase supplies of shortage commodities, such as directly increasing the import of shortage commodities or raw materials for the production of shortage commodities.

Now we have a problem: Since rising purchasing power during the economic contractive period is not caused by government spending, credit expenditures, or foreign exchange revenues, where does it come from?

There are three potential sources:

Personal savings. During the period of economic contraction, residents may withdraw personal savings due to changing expectations and turn them into purchasing power for shortage commodities, thus pushing price level higher.

Personal cash on hand. Cash on hand, considered either pocket money or cash withheld to be spent, will likely be spent and drive price level up when there is change in people's expectations.

Corporate after-tax earnings. Businesses can utilize after-tax earnings to cover corporate expenditures or reward their employees, turning aftertax earnings into personal consumption by employees who purchase shortage commodities and pushing price level higher. But it should be noted that if businesses are driven by profitability and governed by longterm growth strategies, they will, during economic contraction, constrain the spending of after-tax earnings, reduce corporate expenditures and employee compensation, and pay more attention to increasing productivity, lowering cost, and preserving capital. On the contrary, if businesses are not driven by profitability and are shortsighted, they will likely ignore economic contraction and use up all after-tax earnings, thus driving price level higher.

Therefore, if the government adopts measures at time of structural imbalance to reduce aggregate demand without mitigating the impact on the market from personal savings and cash on hand, potential stagflation will turn into reality. Likewise, if the government fails to reform enterprise operation mechanism while reducing aggregate demand, businesses will lack the mechanism to pursue profitability as well as corporate governance for distributing after-tax earnings, business behavior will remain shortsighted, and potential stagflation will likely turn into reality.

Stagflation is very harmful to the economy. It is not comparable to stable economic growth and even worse than inflation during economic growth. As for current Chinese economy, it is imperative to reduce aggregate demand. Our research will be focused on preventing stagflation while reducing aggregate demand. Of course, we also have to stress the importance of lowering economic imbalance by increasing effective aggregate supply. If excessive reduction of aggregate demand leads to lower effective aggregate supply, the purpose of reducing aggregate demand to balance supply shortage will unlikely be fulfilled. In addition, we must also further analyze the abovementioned issues including personal savings, cash on hand, and enterprise operation mechanism in search of an effective solution to stagflation.

1. Personal savings

In order to avoid run on the bank prompted by changing personal expectations at time of lower aggregate demand, we can raise interest rate as necessary and employ tools such as inflation-protected savings and savings for forward purchases to stabilize personal savings. Meanwhile, the government should divert a portion of personal savings to purchasing houses and financial instruments. Investments in housing and financial instruments are protected against inflation and are able to turn shortterm capital into long-term capital or changing consumption funds into production capital. This is an effective method of redistributing personal savings.

2. Cash on hand

Cash on hand is primarily treated the same way as personal savings. The government should turn cash on hand into personal savings and purchasing power for housing and financial instruments. Meanwhile, the government should also encourage small business owners and peasants to turn their cash on hand into production capital so as to increase the supply of capital and avoid exorbitant and extravagant consumption.

3. Corporate operation mechanism

Increasing supply relies on deepening enterprise reforms, which, for example, includes motivating enterprises and their employees to facilitate the recombination of production factors and accelerating the adjustment of the industrial structure. Suppressing demand also relies on deepening enterprise reforms. We will discuss later on in the book that reforming enterprises is nothing but reforming corporate operation mechanism and that only when driven by economic interests can an enterprise care about how to use retained earnings, thus preventing corporate shortsightedness. Having said that, how do we reform corporate operation mechanism? Obviously, the subcontracting system is not sufficient, because it does not sever the relationship between enterprises and their administrative agencies. Enterprises under the subcontracting system have not been goods producers with decision-making authorities and financial responsibilities. The subcontracting system should gradually migrate to the shareholding system. Economic activities under the shareholding system are driven by investors' interests. Macroeconomic regulatory plans can be drafted in accordance with the long-term interests of enterprises structured under the shareholding system. Driven by long-term economic interests, investors will voluntarily control their utilization of after-tax earnings to avoid shortsightedness, i.e., maximizing short-term interests by sacrificing long-term interests. Hence, corporate myopia, i.e., depleting retained earnings, can potentially be prevented.

The above discussions allow us to draw the following conclusion: Stagflation cannot be completely ruled out if there is structural imbalance. Stagflation can be prevented, as long as we devote to increasing effective supply while suppressing demand, take necessary measures to stabilize personal savings, try our best to divert deposits and cash on hand toward purchasing houses and securities, and deepen enterprise reforms by establishing the enterprise mechanism following the principle of maximizing economic interests. In other words, when these conditions are met, the economy will not be expected to experience stagflation. Instead, the economy will see medium economic growth and declining inflation rate.

This section describes stagflation in the socialist economy through a brief analysis. The following sections will present a detailed analysis of issues related to government regulation and enterprise reforms under the coexistence of commodity supply gap and demand shortfall.

1.2.5 The Need to Reconsider Resource Allocation

One of the purposes of studying economics is to find a satisfactory system or mechanism that facilitates efficient utilization of natural resources and effective resource allocation, which contributes not only to increasing national wealth but also to fair distribution of wealth or income. Ignoring resource allocation is actually forgetting the purpose of economics as a science. Existing research on resource allocation since the inception of classical political economics has revealed two trends: One believes that the market is the only effective mechanism that can perfectly and effectively allocate various limited resources in a society. Resource allocation is no more than the automatic regulation of the economy by the market. The other trend believes that the market mechanism is fairly limited in terms of resource allocation processes and results. The limitation of market regulation reflects either inefficient utilization of societal resources, which causes idling or waste of resources, or a mismatch between resource allocation and income distribution, which leads to wider income gaps despite relatively effective resource allocation and higher national wealth under the market mechanism. Such circumstance calls for government regulation or planned mechanism in replacement of the market mechanism so as to overcome its limitation.

In our study of resource allocation in current Chinese economy, it is not difficult to find that various schools of thoughts on resource allocation, despite the fact that many are useful, are not applicable to the realities of the Chinese economy. Given the Chinese economic disequilibrium, the belief that the market is the only effective mechanism to allocate resources is apparently incomplete. If the market pricing mechanism is selected as a starting point to resolve resource allocation issues, we will likely see considerable economic chaos. This is because in an economic environment where the market has not been fully developed and enterprises have not become independent decision-makers and often face noneconomic obstacles, to realize efficient utilization and effective allocation of resources first and foremost requires that enterprises be goods producers that are financially independent and responsible for their own investment and operations and that the market continue to perfect. Even after enterprises are motivated, endowed with decisionmaking authorities, full reliance upon price regulation is not sufficient to achieve efficient utilization and effective allocation of resources if constraints on resources are not removed. All these points demonstrate the complexity of resource allocation under disequilibrium conditions, which is why we have to come back and reconsider the issue of resource allocation according to current economic realities in China.

The fact that the Chinese economy is susceptible to stagnation, inflation, or stagflation, which is related to resource misallocation, clearly demonstrates the complexity of resource allocation in the current economy as well as the difficulty to find a viable solution. In other words, neither the model of resolving resource allocation issues by solely using the market mechanism nor one that replaces the market mechanism with the planned mechanism is able to reveal the true root cause of the problems and to provide a real solution. Our emphasis on "realistically describing the Chinese economy only by understanding China in the first place" does not mean we can look down on economic theories that provide appropriate guidance. Without economic theories and the analysis conducted according to these theories, we will be inundated with piles of tedious and unsystematic details or descriptions. Therefore, we value the guiding role of economic theories. But it does not mean we are able to draw an easy conclusion on resource allocation simply according to some superficial phenomena of economic activities. Instead, it requires us to look for economic theories that can be applied to resolve resource allocation issues in China. Even though there are many difficulties down the road, we will succeed eventually as long as we follow the research path that is consistent with Chinese realities.

As it is necessary to reconsider resource allocation issues, we can naturally reach the following conclusion: A theory on resource allocation applicable to China must follow real Chinese situations. In order to meet this requirement, the theory on economic disequilibrium is hereby proposed as an economic theory that is conducive to resolving resource allocation issues in socialist society. Mj6CGA1Go/6e6rBg++EN4JOrsyJ0p9OWCVO2GvW+K9FdAJze3s6jHDYqivDIaFnR

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