The Economics of Involution: A Division-of-Labor and Incentives Perspective
I recently attended some lectures by Professor Wang Yongqin and found them very interesting, so I am recording them here.
Professor Wang’s doctoral advisor was Oliver Hart (Nobel laureate 2016, known for incomplete contracts and the ownership of the firm). Professor Wang is himself building his own macroeconomic understanding from a financial angle. In his analytical framework, the important financial structures are debt, equity, and collateral. Within this framework he strings together China’s involutionary competition, economic growth, the official promotion tournament, and tax incentives as economic theories.
The Manifestations of Involutionary Competition: Externalities from Division of Labor
Has China fallen into involutionary competition?
The UK and the US have held a stable annual growth rate of about 2%, while China, Germany, and other countries briefly grew at around 10% before rapidly dropping to 4%. That shift may indicate that China is facing a dynamic transition challenge.
The concrete manifestations of involution are:
- The high homogeneity of actors
- Competition on a single dimension only
- Insufficient innovation
In China, first, people have fallen into involution. As the economy slows, homogeneous zombie firms multiply, enterprise wages fall, the labor distribution relationship deteriorates, consumption is insufficient, and vicious competition creates a vicious cycle.
Second, industrial policy has fallen into involution. Every region’s policy drifts toward convergence, detached from local comparative advantage.
This contradiction appears at different levels in the same form internationally and domestically.
As I once noted in Is This the Innovation We Mean?:
If everyone does what they are good at, everyone divides labor, and total social welfare rises. Let the US innovate, for example, because that suits it, and let China manufacture, because that is our comparative advantage. But in reality, for the sake of an autonomous and controllable industrial chain, the US seeks to bring manufacturing back while China seeks disruptive innovation. At that point the choice of division of labor aims at defeating the other side, international trade relations deteriorate, and countries fall into involutionary competition with one another.
The same holds domestically. The state prefers each region to divide work and cooperate, but regions, all chasing GDP, pursue similarly comprehensive industrial chains. So the global optimum of “small and refined” and the local optimum of “big and complete” come into conflict, producing a prisoner’s dilemma.
Because comparative advantage is dynamic, the prisoner’s dilemma is dynamic too. In Adam Smith’s view, the division of labor determines the market. We can then also say that the division of labor determines the share of market profit. When China’s comparative advantage shifts from manufacturing to innovation, the formerly innovative countries feel threatened.
An example of division of labor and markets: The Ministry of Commerce released its “China’s Position on the So-Called ‘Overcapacity’ Issue.” China holds that protectionism only disrupts the global trade order. How should we read this? A Zhihu answer by Gu Du Xian Yun
The development structure opposite to involution is Adam Smith’s “great society” and Hayek’s “extension of the order”: everyone divides labor, everyone does their own assigned work, and different people’s work complements the rest. It is the opposite of homogeneous involutionary competition.
That is, each person considers their own optimal local division of labor, yet under the general equilibrium the global development deteriorates.
In Professor Wang’s view, building a great society requires a sound property-rights environment, and the reality of incomplete contracts all around brings various externalities.
This is why Professor Wang has recently published a lot of research on judicial reform and financial-market development.
Financial System, Fiscal System, and Economic Governance
The Financial System
In Professor Wang’s view, the key to financial order lies in understanding insurance, collateral, and information.
-
Information means we know what to do.
-
Insurance means we dare to do it.
-
Financing (collateral) means we can do it.
-
Property-rights protection represents the incentive for innovation (patents, for example).
-
Collateral can supply enterprises with financial strength.
Collateral means trading today’s assets for tomorrow’s ability to pay. China has used real estate as a major form of collateral, which brings a big hidden danger: real estate is a non-renewable resource, and the potential of property-rights confirmation (quequan) in Chinese real estate has not yet been released.
- First, China has overleveraged its real-estate collateral, losing more credit in the future.
- Second, stocks can absorb consequences internally, but collateral carries externalities. Real estate as collateral has a strong multiplier effect. Real estate is a general-purpose collateral. Any enterprise in any industry can use real estate as collateral. Once the economy turns down and the collateral value of real estate falls, every industry takes a hit. (Debt is bad for innovation.)
- Third, property-rights confirmation in Chinese real estate is insufficient. Once rights are confirmed, real estate can serve as collateral. Otherwise it has only the use value of its physical attributes. In Latin America, for example, illegal self-built housing has only physical residential attributes, without a property-rights environment that can be turned into collateral. In China the issue is that a large amount of real estate has not been confirmed: rural land belongs to the collective, for instance, and cannot be turned into collateral.
Property-rights protection and national development can be divided into four quadrants:
| Weak property-rights protection | Strong property-rights protection | |
|---|---|---|
| Strong competitiveness | China | United States |
| Weak competitiveness | Developing countries | Europe |
Based on this division of property rights and competitiveness, development can be divided into several stages:
- Step one: the development trap
- Step two: the middle-income trap
- Step three: imitative innovation
- Step four: innovation, or improved innovation, or involutionary competition
The move from step three to step four can have different outcomes. The crux is whether the local property-rights structure is sound and whether society’s ability to safeguard innovation is sufficient. Without a sound property-rights structure, firms lack collateral, financial strength, and innovative capacity. Property-rights protection is also the incentive mechanism for innovation. And without a sufficient social financial system to fund and protect enterprises, firms tend toward harmful involutionary competition.
The Fiscal System
The first issue is the incentive objective:
One reason for involutionary homogeneity is the singleness of the incentive objective. China stresses high-quality development, but GDP remains the unified yardstick.
The second issue is the fiscal system:
China’s main tax revenue is the value-added tax (VAT), which is levied on the place of production. Local governments therefore prefer to keep firms local. Even if a firm is losing money, as long as its VAT is positive, the government has an incentive to keep it at home, which breeds local protectionism, local fragmentation, and related problems.
How to Govern
- How to break the cycle: protect property rights, for example by protecting private enterprises and confirming property rights in real estate.
- A financial system that gets out of involution.
- Reform of the involutionary competitive tax system.
- Improving social security and the safety-net system. The government’s role shifts toward primarily providing public goods such as health care and education.