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Private ownership: The real source of China’s economic miracle
Even many Western economists think China has discovered its own road to prosperity, dependent largely on state financing and control. They are quite wrong. December 2008 ? Yasheng Huang
The credibility of American-style capitalism was among the earliest victims of the global financial crisis. With Lehman Brothers barely in its grave, pundits the world over rushed to perform the last rites for US economic ideals, including limited government, minimal regulation, and the free-market allocation of credit. In contemplating alternatives to the fallen American model, some looked to China, where markets are tightly regulated and financial institutions controlled by the state. In the aftermath of Wall Street’s meltdown, fretted Francis Fukuyama in Newsweek, China’s brand of state-led capitalism is “looking more and more attractive.” Washington Post columnist David Ignatius hailed the global advent of a Confucian-inspired “new interventionism”; invoking Richard Nixon’s backhanded tribute to John Maynard Keynes, Ignatius declared, “We are all Chinese now.”
But before proclaiming the dawn of a new Chinese Century, leaders and executives around the world would do well to reconsider the origins of China’s dynamism. The received wisdom on the country’s economic miracle—it was a triumph of technocracy, in which the Communist Party engineered a gradual transition to the market by relying on state-controlled businesses—gets all the important details wrong. This standard account holds that entrepreneurship, private-property rights, financial liberalization, and political reform played only a small role. Yet my research, based on a detailed analysis of the Chinese government’s survey data and government documents at the central and local levels, indicates that property rights and private entrepreneurship provided the dominant stimulus for high growth and lower levels of poverty.
We often read that gradualism was the key to China’s successful transition from Marx to the market; many accounts laud Beijing for eschewing Russian-style shock therapy in favor of a more pragmatic approach that created a hospitable business environment and allowed private companies to grow organically. This narrative suggests China’s economy grew progressively more liberal and market-oriented through reforms that were introduced on a small scale in the 1980s and gathered momentum in the later half of the ’90s. Not so. What actually happened is that early local experiments with financial liberalization and private ownership, in the 1980s, generated an initial burst of rural entrepreneurialism. Those earlier gains—not the massive state-led infrastructure investments and urbanization drive of the 1990s—laid the true foundation for the Chinese miracle.
Although many experts contrast China’s grand infrastructure projects and gleaming factories built using foreign money with India’s dilapidated highways and paltry foreign-direct-investment flows, this point of view overstates the contribution of public spending and foreign investment to China’s growth. Neither of these forces assumed huge proportions in China until the late 1990s—long after relaxed financial controls and rural entrepreneurship prompted the initial growth surge, during the 1980s.
In that decade, China’s economy grew more rapidly than it did in the 1990s and brought better social outcomes: poverty declined, the gap between rich and poor narrowed, and labor’s share of GDP—a measure of the way average people benefit from economic growth—rose substantially. From 1978 to 1988, the number of rural people living below China’s poverty line fell by more than 150 million. In the 1990s, their number fell by only 60 million, despite almost double-digit increases in GDP growth and massive infrastructural construction. What’s more, in the 1980s China’s growth was driven far less than it is today by investments as opposed to consumption. In other words, entrepreneurial capitalism, unlike state-led capitalism, not only generated growth but also dispersed its benefits widely. Entrepreneurialism was virtuous as well as vibrant.
Big cities like Beijing, Shanghai, and Shenzhen are routinely extolled in the Western press as vibrant growth centers (exhibit). China’s rural areas, if mentioned at all, typically figure as impoverished backwaters. But a close analysis of the economic data reveals that these breathless descriptions of China’s modern city skylines have it exactly backward: in fact, the economy was most dynamic in rural China, while heavy-handed government intervention has stifled entrepreneurialism and ownership in the urban centers.
The significance of this last point is impossible to overstate. Indeed, much of the history of Chinese capitalism can be characterized as a struggle between two Chinas: the entrepreneurial, market-driven countryside versus the state-led cities. Whenever and wherever rural China has the upper hand, Chinese capitalism is entrepreneurial, politically independent, and vibrantly competitive. Whenever and wherever urban China dominates, Chinese capitalism tends toward political dependency and state centricity.
Shanghai is the most visible symbol of China’s urban development. Its modern skyscrapers, foreign luxury boutiques, and top-ranking GDP per capita make it China’s model city—a glittering testament to the success of state-led capitalism. Or is it? By more meaningful measures of economic achievement, Shanghai’s rise is far less impressive than that of Wenzhou, an enclave of entrepreneurial capitalism a few hundred miles to the south, in Zhejiang province. In the early 1980s, Wenzhou was known for little more than its struggling farmers. Of five million inhabitants, fewer than 10 percent were classified as urban. Today, Wenzhou is China’s most dynamic municipality, teeming with businesses that dominate European garment markets. By contrast, Shanghai, once home to China’s earliest industrialists, is now oddly bereft of native entrepreneurs.
Wenzhou’s transformation resulted almost entirely from free-market policies. As early as 1982, officials there were experimenting with private lending, liberalized interest rates, cross-regional competition by savings and loans organizations, and lending to private-sector companies. The Wenzhou government also worked to protect the property rights of private entrepreneurs and to make the municipality friendly to business in many other ways.
Does indigenous entrepreneurship make a difference for human welfare? Abundantly. In GDP per capita, Shanghai is almost twice as rich as Zhejiang, where Wenzhou is located (detailed data on Wenzhou are harder to get). But if the measure is household income—the actual spending power of average residents—the two regions are equally prosperous. In 2006, a typical Shanghai resident earned a household income 13 percent higher than that of a typical Zhejiang resident, but in Shanghai the level of unearned income (for example, government benefits) was almost twice as high as in Zhejiang. Earned income was about the same for average residents of the two places. On average, Shanghai residents earned 44 percent less than their counterparts in Zhejiang from operating businesses and 34 percent less from owning assets. The implication: state-led capitalism may lift urban skylines and GDP statistics but not actual living standards.
The contrast is clearer still if you examine the economic profiles of Zhejiang province and its northern neighbor Jiangsu province. The two make for a near-perfect comparison. Their geographic conditions are almost identical: both are coastal, with Jiangsu to the north of Shanghai and Zhejiang to the south. They also have similar business histories: both contributed significantly to the ranks of industrialists and entrepreneurs in prerevolutionary Shanghai. During the postreform years, however, Jiangsu courted foreign investment and benefitted significantly from public-works spending; Zhejiang did not. The results of that difference are startling.
Jiangsu was richer than Zhejiang 20 years ago, but today it is poorer, lagging behind in every significant measure of economic and social welfare. On average, Zhejiang’s residents earn significantly more from assets than their northern neighbors do, live in larger houses, and are far more likely to own phones, computers, color televisions, cameras, or cars. They also enjoy lower rates of infant mortality, a longer life expectancy, and higher literacy. Notably, income inequality is far lower in Zhejiang than in Jiangsu. How to account for Zhejiang’s greater prosperity? The most compelling explanation is that in Jiangsu, the authorities meddled in the economy and discriminated against local businesses in favor of foreign capital. Officials in Zhejiang granted free rein to indigenous entrepreneurs, allowing them to build larger, more dynamic local supply chains.
The real mystery of China’s miracle isn’t how the economy grew, but how Western experts got the growth story so wrong. One answer is that outsiders misunderstood the nature of one of China’s most basic economic institutions: township and village enterprises, which some of the West’s best-known economists have celebrated as the epitome of capitalism with Chinese characteristics—innovative hybrid entities that achieved high growth despite government control. Nobel laureate Joseph Stiglitz, for example, extolled them for offering an ingenious solution to a problem common to economies in transition from socialism to capitalism: asset-stripping by private investors.1 These enterprises, he argues, are a form of public ownership that prevents plundering while achieving the efficiency of private-sector companies.
In short, Western economists have often assumed township and village governments own these enterprises. As recently as 2005, Douglass North, another Nobel winner, stated in the Wall Street Journal that they “hardly resembled the standard firm of economics.”2 But the evidence suggests otherwise. A policy document issued by the State Council on March 1, 1984, includes the first official Chinese reference to township and village enterprises. It defined them as “enterprises sponsored by townships and villages, the alliance enterprises formed by peasants, other alliance enterprises, and individual enterprises.” The term “enterprises sponsored by townships and villages” referred to the collective undertakings townships and villages own and run. All the other entities mentioned in the policy document were private businesses: single proprietorships or larger private companies with a number of shareholders—precisely “the standard firm of economics.” Official usage of the term “township and village enterprise” has been remarkably consistent: it always includes private businesses as well as those sponsored by governments.
Western economists erred because they assumed the term referred to ownership. But Chinese officials understood it in the geographic sense—businesses located in townships and villages. The records of China’s Ministry of Agriculture attest that privately owned and run entities dominated the total pool of these enterprises. During the years from 1985 to 2002, the number of collectively owned ones peaked in 1986 at 1.73 million entities, while the number of private ones soared to more than 20 million, from about 10.5 million. In other words, the increase in the number of these enterprises during the reform era was due entirely to the private sector. By 1990, within the first decade of reform, such private businesses accounted for 50 percent of total employment in town and village enterprises and claimed 58 percent of their after-tax profits.
Confusion about the real origins of Chinese growth has clouded foreign perceptions of the emergence of Chinese companies in the international marketplace as well. It is often said China heralds a new business model for global competition, in which state ownership and the judicious use of government financial controls combine to create a unique source of competitiveness. The computer maker Lenovo is often touted as a product of China’s unconventional business environment.
But Lenovo owes much of its success to its ability, early on, to establish legal domicile and raise capital in Hong Kong, arguably the world’s most freewheeling market economy. Lenovo got its initial financing from the Chinese Academy of Sciences, in 1984, but thereafter secured all of its significant investment from Hong Kong.3 In 1988, the company received HK $900,000 (US $116,000) from the Hong Kong–based company China Technology to invest in a joint venture that would enable Lenovo to claim the city as its legal domicile. In 1993, Hong Kong Lenovo went public on the Hong Kong Stock Exchange in a US $12 million IPO. Lenovo is a success story of Hong Kong’s market-based financial and legal system, not of China’s state-controlled financial system.
As China absorbs the lessons of the Wall Street debacle and prepares itself for a global economic slowdown, the worst thing the country could do would be to embrace the notion that it has discovered a new development formula more effective than free markets. The real lesson of China’s economic miracle is that it was actually remarkably conventional—based on private ownership and free-market finance. China’s experience offers the world a timely reminder that reforms designed to encourage these forces really work.
Why Americans pay more for health care
The United States spends more on health care than comparable countries do and more than its wealth would suggest. Here’s how—and why.
December 2008 ? Diana M. Farrell, Eric S. Jensen, and Bob Kocher
The health care debate in the United States excites great passion. Issues such as how to make care available, to structure insurance, and to rein in spending by the government, corporations, and individuals frequently take center stage. Often missing, though, are basic economic facts. New research from the McKinsey Global Institute (MGI) and McKinsey’s health care practice sheds light on a critical piece of the puzzle: the cost of care.
Our research indicates that the United States spends $650 billion more on health care than might be expected given the country’s wealth and the experience of comparable members of the Organisation for Economic Co-operation and Development (OECD). The research also pinpoints where that extra spending goes. Roughly two-thirds of it pays for outpatient care, including visits to physicians, same-day hospital treatment, and emergency-room care. The next-largest contributors to the extra spending are drugs and administration and insurance.
It’s not clear whether the United States gets $650 billion worth of extra value. Parts of the US health care system, such as its best hospitals, are clearly world class. Cutting-edge drugs and treatments are available earlier there, and waiting times to see physicians tend to be lower. Yet the country lags behind other OECD members on a number of outcome measures, including life expectancy and infant mortality. Furthermore, access to health care is unequal: more than 45 million Americans lack insurance.
The challenge for health care reformers is to retain the current system’s strengths while addressing its deficiencies and curbing costs. That won’t be easy. Our research on the system’s costs and the incentives underlying them indicates that without the involvement of all major stakeholders (such as hospitals, payers, and doctors) reform is likely to prove elusive. The research also suggests that while there are many possible paths to reform, it is unlikely to succeed unless it deals comprehensively with health care demand, supply, and payments.
A $650 billion spending gap
Across the world, richer countries generally spend a disproportionate share of their income on health care. In the language of economics, it is a “superior good.” Just as wealthier people might spend a larger proportion of their income to buy bigger homes or homes in better neighborhoods, wealthier countries tend to spend more on health care.
Yet even accounting for this economic relationship, the United States still spends $650 billion more on health care than might be inferred from its wealth. MGI arrived at this figure by using data from 13 OECD countries to develop a metric called estimated spending according to wealth (ESAW), which adjusts health care expenditures according to per capita GDP. No other developed country’s spending above the ESAW level approaches that of the United States (Exhibit 1).

Is it paying so much more because its people are less healthy than those of other countries? Our research indicates that the answer is no. While lifestyle-induced diseases, such as obesity, are on the rise in the United States, the most common diseases are, on average, slightly less prevalent there than in peer OECD members. The factors contributing to the lower disease rates include the relatively younger (and therefore less disease-prone) population of the United States, as well as the low prevalence of smoking-related problems. Factoring in the average cost of treatment for each disease, we still find that the relative health of the US population does not account for the higher cost of health care.
Analyzing the problem
MGI broke down health care costs into their components to identify the sources of this higher-than-expected spending (Exhibit 2). Outpatient care is by far the largest and fastest-growing part of it, accounting for $436 billion, or two-thirds of the $650 billion figure. The cost of drugs and the cost of health care administration and insurance (all nonmedical costs incurred by health care payers) account for an additional $98 billion and $91 billion, respectively, in extra spending. By contrast, US expenditures on long-term and home care, as well as on durable medical equipment (such as eyeglasses, wheelchairs, and hearing aids), is actually less than would be expected given the country’s wealth.
Outpatient care
The high and fast-growing cost of outpatient care reflects a structural shift in the United States away from inpatient settings, such as overnight hospital stays. Today, the US system delivers 65 percent of all care in outpatient contexts, up from 43 percent in 1980, and well above the OECD average of 52 percent. In theory, this shift should help to save money, since fixed costs in outpatient settings tend to be lower than the cost of overnight hospital stays. In reality, however, the shift to outpatient care has added to—not taken away from—total system costs because of the higher utilization of outpatient care in the United States.
We evaluated the economic impact of this structural shift by analyzing US inpatient care and comparing it with the practices of other OECD health systems. We estimate that the United States saves $100 billion to $120 billion a year on inpatient care thanks to shorter hospital stays and fewer hospital admissions. If we attribute these savings to the US health system’s ability to provide care in outpatient settings, that would reduce above-ESAW outpatient expenditures—but only to $326 billion. This enormous figure still represents half of the US health care system’s $650 billion in extra costs (Exhibit 3).
The two largest and fastest-growing categories of outpatient spending are same-day hospital care and visits to physicians’ offices (Exhibit 4). From 2003 to 2006, the cost of these two categories increased by 9.3 and 7.9 percent a year, respectively. Growth in the number of visits played only a modest role in explaining the increase in costs—the number of same-day hospital visits rose by 2.1 percent annually, and the number of visits to physicians’ offices remained relatively flat during this period.
Far more important was a surge in the average cost per visit resulting from factors such as the additional care delivered during visits, a shift toward more expensive procedures (for example, diagnostic ones such as CT and MRI scans), and absolute price increases for equivalent procedures.1 In all likelihood, costs have also gone up because over the past decade there has been a marked shift in the delivery of care, from general practitioners to specialists.
Behind those proximate causes, several forces contribute to the rising cost of outpatient care across the entire range of settings, not just same-day hospital stays and visits to physicians’ offices. For starters, outpatient care is highly profitable—US hospitals earn a significant percentage of their profits from elective same-day care—which prompts investments in the facilities and people supporting it. These investments can be recouped only by offering more (and more expensive) services. The significant degree of discretion that physicians have over the course and extent of outpatient treatment also probably plays a role, as does the fee-for-service reimbursement system, which creates financial incentives to provide more outpatient care.
Finally, there is no effective check on it. On average, the out-of-pocket expense of patients represents only 15 percent of the total cost, so they are relatively insensitive to it and apt to follow the advice of their physicians. Other countries also have low out-of-pocket expenses but use supply-oriented controls to compensate for the lack of demand-side value consciousness.
Pharmaceuticals
After outpatient care, the category with the highest above-ESAW expenditures, at $98 billion, is prescription drugs—not because Americans are buying more of them but rather because they cost 50 percent more than equivalent products in other OECD countries (Exhibit 5).2 The United States also uses a more expensive mix of drugs; the price of a statistically average pill is 118 percent higher than that of its OECD equivalents. One reason is probably that new drugs, which tend to carry a price premium, are widely prescribed one to two years earlier in the United States than in Europe.
Several frequent explanations for higher US drug prices deserve examination. One is the wealth of the United States, which enables it to spend more on economically superior goods, such as drugs. Another is that high US prices subsidize research and development for the rest of the world. Marketing and sales spending by companies is higher in the United States than in other OECD countries (which generally restrict direct-to-physician or consumer advertising), and that also could play a role.
But none of these factors, by itself, can explain the gap between the price of drugs in the United States and the rest of the OECD. When we adjust for US wealth, we find that the country’s branded-drug prices should carry a premium of some 30 percent, not 77 percent for branded small-molecule drugs. Similarly, if global pharma R&D spending—$40 billion to $50 billion in 2006—were financed entirely through higher branded-drug prices, the US price premium over similar countries would be 23 to 28 percent. Finally, in 2006 the sales and marketing expenditures of US pharma companies came to $30 billion to $40 billion, only 17 to 23 percent of current US prices.
Health administration and insurance
The third-largest source of above-ESAW spending is health administration and insurance, at $91 billion. In this category, the United States spent $486 per capita in 2006—twice the outlay of the next-highest spender, France, with $248, and nearly five times the average of $103 across peer OECD countries.
Of the $91 billion in above-expected spending, $63 billion is attributable to private payers. Profits and taxes—a negligible expense in OECD countries with single-payer systems—account for nearly half of this total. The cost of public administration for Medicare, Medicaid, and other government programs accounts for the remaining $28 billion in US above-ESAW spending.
These higher costs largely reflect the diversity and number of payers as well as the multistate regulation of the US health care system. Its structure creates additional costs and inefficiencies: redundant marketing, underwriting, claims processing, and management overhead. In other OECD countries, with less-fragmented payment systems, these costs are much lower. Interestingly, we find that given the structure of the US system, its administrative costs are actually $19 billion less than expected, suggesting that payers have had some success in restraining costs (Exhibit 6).
Of course, the US multipayer system could create value to the extent that it develops effective programs to promote health and prevent disease, competes to drive down prices, innovates to improve customer service or benefits, or offers patients greater choice. But do the virtues of the US system outweigh its inefficiencies, and can these inefficiencies be reduced within its current structure?
A framework for reform
The United States can take no single path to address the level and growth of every one of its health care costs. Any reform effort should involve all of the system’s stakeholders, for the inclusion of hospitals, payers, and doctors in the reform effort will increase the odds of arriving at a plan for change that each party will truly embrace. Furthermore, each party can play a distinct role in addressing the full spectrum of issues that must be part of any major system overhaul. For each of these areas, there are several possibilities for reform—such as raising public awareness, creating appropriate incentives, mandating desired behavior, and taking direct action.
For health care reform to generate lasting improvements in cost, quality, access, and equity, it must effectively address supply, demand, and payment.3 A number of our McKinsey colleagues recently completed an effort to determine what would be required to change trends in health care costs fundamentally. Here, we briefly lay out the principal issues for consideration by all health care reformers.
Demand
The general health of the US population is a significant issue. Although disease is no more prevalent in the United States than in peer OECD countries, the health of its population is falling, and this decline contributes to the growth in medical costs. In fact, our analysis suggests that in the two-year period from 2003 to 2005, the decline raised them by $20 billion to $40 billion. Reformers should therefore focus on the preventative efforts that present the largest opportunity to improve overall health and thereby save money.
Equally important is the lack of any real value consciousness. In the United States, the “average” consumer of health care pays for only 12 percent of its total cost directly out of pocket (down from 47 percent in 1960), as well as for 25 percent of health care insurance premiums, a share that has stayed relatively constant for the last decade. Well-insured patients who bear little, if any, of the cost of their treatment have no incentive to be value-conscious health care consumers.
Moreover, even if they wanted to be value conscious, they don’t know enough. Despite recent efforts to expand consumer access to information on health care, its cost and quality remain opaque—arguably more so than in any other consumer industry. Consumers also know vastly less than providers do and therefore understandably rely on the advice and guidance of physicians. If Americans are to become more value-conscious consumers of health care, reformers must therefore determine how to create an appropriate level of price sensitivity and to give patients the right information, decision tools, and incentives.
Supply
In many industries, such as consumer electronics, innovation tends to drive down prices. The opposite is true in health care, where lower prices don’t necessarily boost sales and may even create the perception of low quality. Instead, innovation tends to focus on the development of increasingly more expensive products and techniques. High-priced technologies, from imaging to surgical equipment, also mean higher reimbursements for providers, who therefore demand cutting-edge products. So what emerges is a constant cycle of cost inflation along the entire health care value chain—from manufacturers of health products to equipment manufacturers to physicians to hospitals to payers and, ultimately, to employers and patients. At each step, the stakeholders absorb part of the cost increase and attempt to pass an even larger one onto the next stakeholder. Reformers must determine how to address this cost inflation cycle while retaining the beneficial aspects of innovation.

Intermediation
Medicare and many commercial payers base their reimbursements for inpatient care on episodes or diagnosis-related groups (DRGs). This forces providers to bear part of the risk of treating a patient and largely creates incentives to use resources efficiently. But fee-for-service reimbursement, the predominant method in outpatient treatment, does not have that effect and actually gives providers strong financial incentives to provide more (and more costly) care, not more value. Fear of malpractice suits boosts care volumes too. Our research indicates that the direct costs of malpractice are limited—about $30 billion in 2006—but the risk of litigation creates an incentive to err on the side of caution. Reformers therefore need to develop more effective financing and payment approaches ensuring that care providers have the right incentives to give patients an appropriate type and amount of care.
Medicare’s role in influencing coverage and pricing dynamics also bears investigation. Private payers use this public program as a critical benchmark, more often than not following its lead, when they make decisions about which new procedures and technologies to reimburse. Because Medicare essentially uses a cost-plus formula to set reimbursement rates, it puts care providers under less pressure to reduce expenses than it could with another reimbursement mechanism. What’s more, trends in the reimbursement rates of commercial payers are strongly correlated—but inversely—with Medicare pricing trends: private insurers grant providers higher increases when Medicare reimbursements grow more slowly. This suggests both that Medicare prices partly drive so-called market prices and that care providers have a significant amount of pricing power with private insurers. Reformers need to determine how public programs, such as Medicare and Medicaid, can lead the market toward rational change in reimbursement approaches and levels.
Reform won’t be easy. But armed with the facts about what the United States spends on different aspects of health care, how much above what might be expected that spending really is, and the underlying economic dynamics of the system, policy makers will have a better chance to curb the growth of costs.