Charter cities can be thought of as the next generation of special economic zones. Today’s guest is Lotta Moberg, a macroeconomic analyst at the Dynamic Allocations Strategies team at William Blair in Chicago. Lotta is considered somewhat of an expert on special economic zones, given that her dissertation explored the entrepreneurial state and the government as an entrepreneurial and commercial actor, as well as special economic zones. This is also the topic of her book, The Political Economy of Special Economic Zones.
In this episode, we discuss everything there is to know about special economic zones, including knowledge and incentive problems, economic activity versus political need, concentrating resources versus implementing them in the economy as a whole, and private versus government initiatives. Lotta shares some of the key determinants for successful special economic zones, the importance of regulatory reform, and why China has been so successful in implementing them, as in the case of Shenzhen. We also go into the differences between charter cities and special economic zones and how the two can complement each other. Tune in today to find out more! Links mentioned in today’s episode can be found below the transcript.
Transcript (edited for clarity):
Mark: Hello and welcome to The Charter Cities Podcast. I’m your host, Mark Lutter, the Founder and Executive Director of The Charter Cities Institute. On The Charter Cities Podcast, we illuminate the various aspects of building a charter city, from governance to urban planning, politics to finance, we hope listeners To the Charter Cities Podcast will come away with a deep understanding of charter cities, as well as the steps necessary to build them.
You can subscribe and learn more about charter cities at chartercitiesinstitute.org. Follow us on social media, @CCIdotCity on Twitter and Charter Cities Institute on Facebook. Thank you for listening.
My guest today is Lotta Moberg. She has a PhD in economics from George Mason University, and is the author of The Political Economy of Special Economic Zones.
Welcome to the show, Lotta.
Lotta: Thank you so much for having me.
Mark: To begin, how did you get into the charter cities and special economic zone space?
Lotta: I was studying economics and I wanted to study development economics, and understand what policies can actually help countries develop. I got into this space very much through special economic zones, which was the topic of my PhD dissertation at George Mason University, and also the topic of a book that I subsequently published.
I started looking into charter cities, Paul Romer was big on charter cities at the time, and I was thinking, maybe I write my dissertation on charter cities. This is such an exciting and very promising policy. I soon discovered that to understand charter cities, you really wanted to understand special economic zones, because this was this model that was out there that’s been tried that wasn’t really all the way there. Then I thought, I would just read that and then I can apply that to charter cities. Then I realized, there wasn’t really much good scholarship on special economic zones.
Nobody’s taken the topic from a broader perspective, tried to conceptualize it. That’s what I ended up setting out to do. That, I feel, was fruitful in many ways. Happy that I ended up there.
Mark: Great. What’s the name of the book? I’ll refer to it in the introduction, but remind our listeners of the name of the book.
Lotta: Sure. It’s The Political Economy of Special Economic Zones.
Mark: If you stop by Chicago, I’m sure Lotta would be happy to sign a copy for you.
Lotta: Yes. I’m standing here with a pen right now.
Mark: Okay. You were interested in development economics and you saw this. What caught you? Because there’s a lot of interesting ideas in development economics. RCTs are hot. We had Banerjee, Duflo and Kremer win the Nobel Prize last year. In addition, there’s this institutional economics aspect. What was it particularly about special economic zones and charter cities that did attract you, given that it has been somewhat under-researched compared to some of the other areas?
Lotta: It was very much coming from a free market perspective, thinking about how do you leverage market forces if there are all these theories about the market not doing things right, so government has to step in and fill the holes. When you start studying the policies having to do with supplying education, foreign aid, and things like that, where resources are concentrated, or directed, in the spaces where governments and bureaucrats are trying to determine where the money should go, it turns out that it often fails in various ways.
Often, there is some knowledge problem. That is, you don’t really know how resources should be well-spent. You don’t really know what the effect is going to be on the incentives and the workings of the local markets and so on and so forth.
You start digging deeper and you’re getting closer to just saying, “Well, how then, if it can’t be government-driven, it has to be market-driven. What kind of policies is that? Where that can actually happen?” Special economic zones, I came across it as this way of creating a space that allows for market development, where that might otherwise not be possible. It might not be possible to do it in the country as a whole, but you can do it in a concentrated space, because that’s really what special economic zones are. It’s a carved-out area, usually where the government designates having some different policies, and often exemptions from taxes, tariffs, and sometimes regulations.
Mark: Cool. You mentioned the knowledge problem and the incentive problem. Can you elaborate a little bit on what those are and particularly how those relate to special economic zones?
Lotta: Sure. The knowledge problem is a problem that, if you are a benevolent government, assuming, making the clear case where you have resources as a government person and you want to spend the wealth to maximize welfare. This is what you study from day one when you study economics. It’s about maximizing welfare. You can have all these equations. You’d think that with all these equations, with all this math that we come up with, we would know how to save the world by now. We wouldn’t have poverty.
The problem is that those models don’t really get you there. If it were the case that you could have an optimal taxation and make everybody better off, or distribute resource in a much smarter way, and there was all these improvements everywhere that you can do, we would be better off. The problem is that those models don’t get you there. It’s really hard from the top-down to know how the market should function.
You see a market, it looks simple. People buy stuff, people demand stuff, people supply stuff, that’s how it’s gonna work. This was the model of a socialist society. That the government can portion out, can predict what that model looks like, how society evolves, what the prices are, and so on. Now we know that when you try that, it actually doesn’t work. The allocation of resources gets worse when you try to do it from the top-down.
The knowledge problem is really that it’s not about socialism today. That’s the extreme version. The knowledge problem is the further away you get from the information you need on the ground to understand how resources should be allocated, the harder it is to allocate those resources in an efficient way.
Mark: Okay. Let me summarize that argument. One way to understand the knowledge problem is that prices transmit information, and prices are an emergent phenomenon from people trading with each other. That allows for this information to then get aggregated. That allows for what might be called “rational economic decisions” to be made, in terms of allocating resources to the sectors that need them most.
If you think, as you mentioned, an extreme example in a socialist country where they have X tons of steel and they can choose to allocate the steel to railways, to factories, to tractors, but how much steel to allocate to these different sectors? In a market economy, they would be able to say, the return for building rail is A, the return for building factories is B, the return for building tractors is C, and be able to allocate based on that.
In a socialist economy, because there are no market prices, you would not be able to effectively tell what the most effective allocation of resources is and that would prevent the resources from going to the highest valued use. Is that a fair summary?
Lotta: Yes, absolutely. That’s the fundamental way of looking at it. Then more concretely for what we’re talking about now, if we’re talking about special economic zones, and you have the government people trying to determine how a zone is going to work, often the more decentralized that decision is, the easier is for those people in government to make that decision. That’s why, on a municipal level, it would probably be much better to have a special economic zone governed on the municipal level than it would be on the state level, even the federal level, in the context of the US.
Mark: Cool. Can you go into a little bit more depth in the incentive problem and what that looks like?
Lotta: Yeah, sure. Now you can take the other extreme. The reason why I’m talking about extremes, just because it makes it easier to define the actual problems, because knowledge problems, incentive problems are often going to be present at the same time. When you think about the incentive problem, you can assume away first the knowledge problem. We just determined that it actually never works. It’s really, really hot. You can’t aggregate that information, have perfect information at the top.
Even if you would have that, you’d still have the incentive problem in place. The incentive problem is that, as a government official, you don’t always have the incentive to maximize the welfare. There’s a reason why you’re sitting in office. A project that you take on will often be very focused on that project and not see the whole picture. The special economic zone is a great example of this. In this case, what you often find is that, if a person in government pursues a specific special economic zone, this is the president, he calls it, “This is the President Zone.” His incentive is to make that zone look good.
He can try to attract resources there. You will not know necessarily, and it’s often very hard to measure this, whether those resources come from the rest of the economy, whether the rest of the economy is actually worse off, and whether on net in your economy, you’re actually better off. What he’s going to say when you come and visit him and you say, “Knock, knock on your door, President. Show me your zone. Is it a success?” He’s going to say, “Obviously, it’s a success. We have all these resources here.”
Often, if it’s government-led, they will spend a lot of money on it. They will build all this infrastructure. If something is failing, they’re going to make sure that they spend more money on it and so on. That’s part of the incentive problem, when it comes to special economic zones. that you’re pursuing a project, like so many government projects generally, that has a certain goal in mind. As someone who pursues the project, your interest is to see that that project lives up to however you advertised it, lives up to what you said it was going to do, so that you can then say, “Oh, therefore, I should hire more people under me. I can build my bureaucracy,” and things like that.
Mark: Great. Let me summarize that again. One way to think about the incentive problem is under a market system, the investors, if they make poor decisions, they lose money, which tends to be a relatively short feedback loop. If it’s a government decision-making body, then that feedback loop tends to be a little bit, let’s say extenuated, where people might like shiny things. The voters might like shiny things, instead of actual monetarily beneficial things. Then second, if, depending on where the support for the politician is, maybe the majority of the support is from their home village, instead of from the country as a whole.
Therefore, they might make decisions to allocate resources to their home village, which might not be economically beneficial, but it benefits their power base. That feedback loop is just different in a way from generating more economic activity versus benefiting a political need, which oftentimes can be economically harmful.
Lotta: Right. You jumped here to the private zone model. If we’re thinking about a government zone though, the incentive problem does suggest that you want to be as close to those people – you want to have some feedback, as you say. A democratic system, or just a system where you somehow get punished for not treating your people well, pursuing bad projects that impoverish people. The question becomes, how decentralized should you be? How close to this decision-making? Well, if you take it to the extreme, if you take it to the next level, it is going to be – well, you want to actually be have it privatized, have a private company doing it.
The benefit of course, of privatized company is that if things go wrong, that will not punish the taxpayers of that jurisdiction. Of course, when a company disappears, jobs disappear. That’s true. In terms of the costs incurred in all the infrastructure and other investments, if you have the private zone model, being one where the government may lease you the land, it might give some little bit of discount on that, but otherwise, it’s a private developed space, you definitely want to maximize the benefit of everyone who uses that zone.
It works more there. It works more like a firm. You think about it like a big conglomerate, where you’re trying to generate profit, so that you can actually charge people for being investing in the zone.
Mark: Great. I think you touched on this a little bit with your discussion of the incentive problem, but how do you judge whether a special economic zone is successful or unsuccessful?
Lotta: It’s hard to judge in the sense that it’s hard to measure. This is where I started seeing how the literature was wrong or was going in the wrong direction. Often, what people try to do is that they say, “Is GDP higher, exports higher in the zone than in the rest of the country?” Usually, if you give benefits, if you cut taxes somewhere, or cut tariffs, you get more development. The question is, is it good for the country as a whole? Often, people don’t really measure that. If you try and measure it for the country as a whole, then you’re into the GDP growth increase. Well, over what period? Often, zones are such a small part of the economy and you have to control for two million factors. It never really works.
How you do it is really exactly getting to the questions that you’re asking here. Is there a knowledge problem? How severe does it seem to be? What is the institutional setup? Is there an incentive problem? Do these policy-makers tend to pursue these zones for their own political benefit? It’s probably going to be very hard just by visiting this place.
I did some field studies in the Dominican Republic and I visited several of the zones there, and they look great. I know that from there, I can’t judge whether it’s a good idea. I can see how they work, but you really need to talk to the people who set things up and understand the structure of who actually gets paid to do this, to understand it. That’s again, where the private model comes, a simple one. If you’re in a free market and you look at a company, you look at your corner restaurant and you’re saying, “Is this is a good idea or not?” They’re in business and people go there. If they have a profit, then they’re producing value, which also gets trickier. You really have to understand it in a deeper level.
It becomes more a political economy. That’s why I call my book The Political Economy of Special Economic Zones, not just the economy. It becomes ultimately, a political question of whether it’s a good idea, and to what extent they’re doing good, to what extent they’re doing damage, or to what extent they might be neutral, or look good.
Mark: Cool. Let’s dive a little bit more into that. If we think about zones, there’s one way to evaluate them, which is, is there more economic activity in that zone than otherwise? You’re suggesting that this is not a good measure, because there could be more economic activity, but it’s basically just subsidized. That economic activity would have taken place somewhere else in the country and has now moved to the zone and it might even be negative, because all of this infrastructure was built in the zone.
What your argument is, is to think about what the institutional framework for the decision-making regarding the zone is. Even there, then evaluating a single zone, might not necessarily be the proper strategy, because you can imagine a national development plan where they say, “Okay, look. We have limited capacity. Because we have limited capacity, we want to focus on one zone. We’re going to build out this infrastructure, but in doing this we’ll attract some multi-nationals. We’ll get these secondary linkages to get some of this jump-started economic development.”
If we look at what’s happening in Ethiopia with their zone program, I think the government – I’m actually not sure, but I think the government is investing relatively heavily in that, both in terms of manpower, as well as in terms of resources. On a pure cost-benefit analysis, it’s possible to conceive of those zones being negative. Then, if you think about these secondary spillover effects, the entire framework might become positive. Does that analysis make sense? How does that fit in to your general framework?
Lotta: Yeah. It is one of the trickier questions. What if you’re talking about concentrating resources, such as infrastructure, to attract investors from abroad? It’s a very specific case. There are several specific cases like that in general. You can talk about for example, if we want more security in our country, isn’t it better to start somewhere and concentrate the police here? That’s an argument to hear about how to create spaces of security and then they can develop them further. It is a hard question.
The question you have to ask is if you wanted to concentrate the resources there, and then you’re going to apply this trade framework there, because remember, special economic zones, what people usually talk about is tax and tariff exemptions. If you think that’s a good idea, why would you not have that in the economy as a whole and allow for those investors to pick their location, and be more flexible with where are you going to put your infrastructure? Why did you pick that spot, if the government then comes out and says, “We need a zone somewhere?”
That’s always the tricky question you have to ask. Often, it is because they want a project, because if you allow them to invest anywhere, it’s really hard to tell a story afterwards, like “Well, we cut some taxes and tariffs, and look, that guy over there established at this other port.” That’s what you have to be skeptical of. There is a case to be made absolutely, that, even if you, in theory, could have done something broadly, something different, maybe you were politically constrained.
Special economic zones are often a way to create more openness, if it’s impossible to do that in the economy as a whole; if there’s opposition from other policy makers, or from the public, and so on. If that’s the context, then that could have been fine that they did that. If it’s just a matter of very targeted industrial policy, often that creates more inefficiencies than the benefits.
Mark: I understand that. One, to push back a little bit, let’s say that agglomeration effects, people are talking about them a lot. They tend to be good. There is a question of, does the government have enough knowledge to see these agglomeration effects? Or is this something where this general framework is better? We’re seeing the return of industrial policy.
How do you view these agglomeration effects as fitting within your arguments, and particularly within special economic zones? Can special economic zones be used to jump-start and create some of these agglomeration effects that could have these beneficial long-term outcomes? If so, then are social economic zones the most effective mechanism to create these, or are these wider reforms a better way to think about it?
Lotta: Agglomeration effects you often get through private initiatives. Special economic zones can do that. Often, it’s going to be more efficient by doing it through having a zone where you can have some framework in your country and saying, “If you establish a zone under these conditions, we’re going to give you these benefits, tax, tariff, maybe regulatory benefits.” Not determining the location, not determining what you have to produce.
If that would open up space for people to set up zones, host them. You can determine what kind of companies. It’s often that investors do that. When you have industrial zones, you’re saying, “We think that we want some synergy effects between these textile manufacturers and these designers, or whatever it can be.” One example when I was in the Dominican Republic was a lingerie producer, where they made sure to invite the people who did the metal-like, those things in the bras, things like that. They were like, “Oh, yeah. We really want them. We wanted them to be in the same space and they’re creating these agglomeration effects.”
Yeah, the economist’s case, yes they work. You can often find more efficient ways than the government to do it, so you should always start there. Is there a reason why you wouldn’t do this through private initiative? That doesn’t mean that it’s possible for the government to create wealth. It’s just that you’re taking a risk. Even if on net you have a positive expected outcome. It is a risky business and you’re risking people’s money, because it’s taxpayers that have to pay for this, who weren’t on the bargain. They didn’t decide that they were going to spend their money this way, so to speak. That’s why I would say, for those various reasons, I would start in the private space. Does that make sense?
Mark: Sure, that does. You discussed this briefly in an answer to a previous question, about when to do zone-based reforms and when to do national level reforms. I was wondering if you could dig a little bit deeper into what is the advantage of doing a special economic zone, or charter city level reform, versus a national level reform and how to think about those two different scenarios?
Lotta: Yeah, that’s funny, because this was really the biggest pushback that I got when I started the idea, when I was launching the idea of writing about this to professors, was “You’re not talking about any beneficial policy here, because if it’s a good idea to lower taxes or whatever they’re going to do, they should do it everywhere. Why wouldn’t they always do it everywhere?” It’s a really good point.
I think that this is when it comes down to the politics. It comes down to, what’s the context under which these zones are created? You had for example, in the Dominican Republic, if we continue that example, you had in the 50s, the president there, Balaguer, he was basically pressed by the US government, had been under US military occupation for a while, and then they put him on there as a president and they said, “Well, now we want you to do as we say, which is to open up your market.”
He had way too many cronies, way too many people that relied on him for market protection, a lot of domestic industries who would say, “No way. No way you’re going to cut tariffs and open up to Americans. We don’t want you to do that.” What was he to do? He established a special economic zone program. In that case, I think you have to do the counterfactual scenario and the counterfactual story here. I would think that, had he not had that alternative, it’s very possible that he would have had to liberalize the Dominican Republic and that would have been a better place as a result.
In that case, I’d say it was a scapegoat. He could say, “Yeah, I’m really pursuing a very active opening up policy, export policy and so on.” In another case, if you do have a government that wants to open up and they’re like, “We want to have more prosperity here. We know that we’re going to benefit from this.” Again, if they have some opposition, they know that the people will rebel, because they think that they’re exposing them to too much competition, or there is this other party that is going to have all these arguments for the next election, that they completely sold their people, and so on.
They know that, “Oh, we can’t just open up the economy.” Special economic zones usually look harmless, and it is harmless in the way that it’s a confined space. It doesn’t cost you anything. You can set up this zone and allow for this, a growth of say, an export industry that you were hoping to promote. In that case, special economic zones, if that’s the way you have to go, then that can be much better than nothing, and it can create reform further on. Because then as a policymaker, you can then look and point to it and say, “Hey, people get jobs here and they’re treated well. We’re getting this export revenue. We could actually grow the economy and come to fruition, make that case, and you can see that it actually works in our country too, to do this.” Possibly, you can open more stores. Maybe eventually, you can then have lower tariffs, taxes, whatever you’re pursuing in the country as a whole.
Mark: Great. What policies do you think are most important for special economic zones to adopt? Not just policies, but also everything else. What would you say are the key determinants for the success of a special economic zone?
Lotta: Well, the traditional model is just tariffs, taxes. I don’t think that that actually takes you very far. What that is, it’s a cost-cutting strategy. Often, what you attract is companies that need to find cheap labor, cheap capital, and things like that. Where they really work well, where you really see the benefit, and you don’t get as much of this extraction of resources from the rest of the economy. It’s really when you get down to regulatory reforms.
When we talk about regulations, you’re talking about opening up opportunities, things that maybe didn’t exist before, that you couldn’t pursue this industry in this country, because the regulatory hurdles were too high. Those are not as common. I know that you work a lot with the zones in the future where you’re really looking at this. It’s still the case that most of the special economic zones in the world are industrial zones. People don’t live there. People go in and work, rolling cigars, or making t-shirts, and they go out at night.
The most common one is still that model, not much of a regulatory reform. I do believe we think about more important in terms of actually making a difference, and be more dynamic, and open up opportunities, and have the opportunity to make political impact, and then therefore, spreading the whole – in the economy as a whole. I would definitely go for the regulatory side of the policies.
Mark: Cool. We definitely focus on the regulatory aspect. I think the other aspects, and I’d like to get your opinion on whether you agree, on the importance of these is, one, we think about defaulting a lot of authority to the zone. Obviously, taxes, regulatory, getting as much zone-level authority as possible. Second, we tend to think about the zone selection being privately led, so that the private sector identifies where the zone might be instead of government, because the government, as you mentioned, with the knowledge and incentive problems, often might not identify the right location.
Third, we tend to think that it’s beneficial to have very large zones. You only get those agglomeration effects, you only get those secondary spillover effects, if the zone is particularly large. If the zone is small, even if the regulations are excellent, you might not get those benefits. Another important thing is not just to have this change in rules, but actually have the legal authority delegated.
Let’s assume the zone has authority over labor law. They might get labor law wrong in the first year. To be able to change it at the zone level without going to the central government, and asking the central government for permission, can allow for this to be more responsive to the needs of the zone residents, businesses, etc., to help improve the economic activity there.
Lotta: This is a great way to illustrate the difference between charter cities and special economic zones. You’re talking about governance here. You’re talking about the structure of something, how something should work. I’m talking about two dimensions only, basically. I mean, two levels here. There’s a regular level and then there’s the simple, like, you pay a bit less. Here’s a discount and you can be in this space. That’s the traditional special economic zone model.
Then we have these pockets, all special economic zones that have gone towards, say that already in the private space. That’s cool. They’ve gone towards allowing for more regulatory exemptions, and that’s when you’re taking this mini-step towards becoming what we would think more as a charter city, which ultimately becomes a mechanism for, I mean, what you’re talking about is mechanism for decentralization. In special economic zones people don’t think of themselves living in a different jurisdiction in any way. They’re not. They’re living in their regular place, so that’s a great example.
It might be interesting to just then think about like, well, what’s the middle ground here? I mean, China might be an example of where you actually did create really big zones. Those zones became – like Shenzhen, became huge cities. What is this now? Well, they don’t have the fence anymore. They recently took down the last pieces of fences, eventually they were somewhere.
Is it now a charter city or special economic zone? I would say, it’s still a special economic zone, because the autonomy is not to the extent that we would want in the charter city. It’s just to make the point that, I would say, most special economic zones are very flat in comparison to what you’re describing. Then there are some that are moving a little bit in that direction.
Mark: Cool. Let’s stay on China and Shenzhen. Why were the Chinese special economic zones so successful?
Lotta: I think that they’re successful a little bit different than most people would say, because most people would say, “Well, they’re always successful because they exported a lot, or stuff like that.” Yeah, we don’t know if that was on net, good for the economy if you just look at that as isolated case.
I think that special economic zones were crucial to drive the reforms in China. Here is the case where not only were they a way to open up when there was a political resistance, but it was also a way to take this next step to therefore, become a showcase and an engine really for further reforms. What happened was basically, there were some businesspeople who wanted to do business with Hong Kong and said, “Hey, can we create a zone by the border of Hong Kong to trade with them? We have to pay so many tariffs when we are shipping goods back and forth.”
After lobbying, I’m sure they were bribing the right people, and talking to the right people, they actually got this through.
How can that happen? Well, it starts in the local level where it’s just enough to get the people who you need approval from to agree to start this zone. It doesn’t mean that they agree that the maximum welfare function is solvable, and therefore, you’re going to make the people better off or something like that. You can, again, just give them a brown envelope. Then you have your zone. The profits that you make from that has to be more, obviously, than what you were given in the brown envelope.
The losses they would expect from having that so, must be smaller than they were getting to. Why would they have any losses? Well, if you’re opening up your economy and it’s under their restriction, then they have this very protected economy going on and that might jeopardize what they’re doing, something that is based more on cronyism.
Once they got that zone started, I mean, it took a while. The four original zones were the ones that lingered there for a couple of decades, the real boom came in the early 90s. What the mechanism was is very much that, because China was actually a pretty decentralized system, we don’t think of it as that, because we think about that it’s communist, but they were very – both fiscally and politically decentralized. They were fiscally decentralized in the sense that local policymakers had incentive to make the economy grow.
Chinese from the top said, “We wanted to create GDP. Do it and you get promoted.” They had an incentive to see that happen. They were politically decentralized in the way that they could actually take these decisions. They needed approval from top, but then trying to figure out how the zones would work and stuff like that, a lot of that could happen actually on a pretty local level. There was an ability and incentive to do this. When you had more of these zones, China started becoming a little bit more of an open economy, so you had more and more people saying, “Well, I actually benefit.” Local policymakers saying, “I might actually benefit more from starting to pursue openness, I want a zone for myself. That would be better for me than to keep my closed-in system here when I live off kickbacks from various people.”
That’s how it grew, and it took a while for the government to be onboard. Deng Xiaoping wasn’t onboard in the beginning. He came on board when most other people started seeing that, “Oh, we can actually benefit from this.” In that way, I think that they were a tool to pursue reforms that may not have happened otherwise. If they would have happened, would have happened slower.
Mark: I think that’s right. When Deng Xiaoping came to power after Mao, there was more of an impetus for opening up. Shanghai, which was the traditional commercial capital of China, was not really an option, because all the capitalists were there, who were evil, they ran to Hong Kong in the immediate post-Civil War era. That was an alternative power base to Beijing. Shenzhen was small, it was non-threatening. There were some of these familial linkages with Hong Kong that allowed for rapid investment.
I think your point about the decentralization of power is quite important I think most people don’t realize that China is relatively decentralized and it’s quite interesting reading some of the articles about Shenzhen. They had a lot of local autonomy. People think about special economic zones and its taxes. In Shenzhen, they basically could do almost whatever they wanted. They reformed labor law. They reformed FDI. They reformed land. They reformed state-owned enterprises. They did have this very wide range of autonomy and they were figuring it out. It wasn’t planned, so like the Dubai International Financial Center for example, was very planned. It was, “We want to be a financial center. We are going to take common law. We are basically going to cut and paste it from the UK, a little bit from Australia and then implement it.”
Where, Shenzhen, they had no idea what they were doing. The Deng Xiaoping quote is, “crossing the stream while feeling for the rocks with your feet,” or something, because there was no clear idea. It was this grand vision, but actually figuring out a lot of the implementation details.
One question that I often maybe struggle with. The Chinese special economic zones were very successful, but nobody else has really copied them. India, in 2005, passed legislation that was supposedly modeled on the Chinese special economic zones, but then failed. Why has nobody actually really understood the lessons from the Chinese special economic zones and why they were successful?
Lotta: I’m afraid that the lesson is that, if you are a government to try to do the same thing, you can’t. If you are determined that you want to do this, you’re already at the stage where the benefits are there. The problems that they had in China that they had to overcome, the bottleneck that they managed to get through, is not the bottleneck that you have. If you haven’t figured out how to benefit your economy in opening up, you got other bottlenecks that you have to deal with instead. I can’t tell you exactly what those are without knowing.
That’s the pessimistic take on this, because it was such a bottom-up process. It’s almost the same, like we were talking about, like, “Well, we can see that firms on the local level, when they are guided by profit and loss and therefore, they create this benefit for us all, okay, great. Now we understand that. How do I create that from the top?” No, no, no. You don’t understand.
It’s a little bit like that with China. They had obstacles that had to do with a government, the party, ruling party that did not want openness, and they were afraid of that. The way that somebody squeezed it in was to create this little small pocket. It’s like, who would have thought? If you are India and you’re saying, “We want to have great exports and whatever we’re seeing as a result.” It’s not only that you’re starting in the wrong end. You’re looking at the result and you’re thinking, “Oh, that’s where I’m going to start.”
If you’re sitting there waiting to be convinced by a process, like the Chinese were convinced by seeing this process and understanding that “I can benefit from this now,” you already have the story in your head. It already happened. It’s just like if you have a domestic tiger, it’s going to be fine until the day when you realize that he can push you around and then it’s going to eat you. It’s a little weird analogy, but I’ll give it.
It’s the question of whether China is a unique story. Could it happen elsewhere? Only in places where they’re not asking for it. Maybe it could happen in Cuba. Maybe it could happen in North Korea, something like that, possible. You’ve got such much smaller economies though, so it’s a little bit harder to see how the geographical diversification that you could have could play on a similar way.
I would be very doubtful that it can happen in Russia. Russia has pursued their top-down version of zones themselves. It’s hard to draw the lesson. You draw the lesson in saying, “Hey, zones work from the bottom up.” In various ways, the way that they were so beneficial in China, overcoming this huge resistance. If that’s going to be the story, you’re going to have to find a place for the resistance. Those are not the people who are going to invite you for a meeting to talk about charter cities.
Mark: Let me push back on you a little bit. There’s obviously some unique things about China. They have a long history of statehood. The state was actually relatively strong in certain senses and was effective at governance. Part of the problem with the Mao, communist era was because they pursued the wrong governance, not because they were ineffective per se.
The second, China had forcibly prevented urbanization from happening. There’s a very large pent-up demand for urbanization, because Mao’s strategy was explicitly to prevent urbanization to keep the system decentralized, because he was terrified of a Russian invasion. Those are somewhat unique. I think there are some similarities to other countries that can be drawn from the Chinese special economic zones, in terms of the devolution of authority to the local government, in terms of the creation of very large zones.
At least some of the conversations that we have been having suggest that there is an openness and there is an appetite. What I see, the mistakes that other countries are making, is that I think the Chinese zone model works in many countries that are urbanizing quite rapidly. That model basically being the decentralization of authority to a city government, very large area, and a lot of flexibility within that city government and, hopefully, pretty heavy private sector involvement, because the private sector tends to make better decisions.
You always need that degree of buy-in from both the government, as well as the investors in the private sector. The government is never really going to be able to lead at the same time, at least based on our experiences, some of the conversations we’re having. If you go and if you present a model, and if it is credible, then you can get a degree of government buy-in for something resembling the Chinese SEZ program. My guess, it’s the bet of the Charter Cities Institute, is that if we can do that, we can be reasonably successful in terms of economic growth and alleviating poverty.
Lotta: Yeah, absolutely. Oh, wonderful words. Let me suggest to you this way of thinking about it. This is the framework that I have in my mind. There are three levels of benefits that zones can have. You were asking for what’s the best one. I would say, I have only one example. I don’t know if you can replicate that.
We already covered, what I would say, the lowest bar. Let’s say lowest, the middle and the high one. Highest one is China overcoming what seems to be an impossible thing to liberalize an economy. The lower one, I would say is overcoming the knowledge and the incentive problem, and that’s exactly what you’re getting at here. China is a great example of that too. They needed to perform in that space for the whole project to work. I’m just saying that what they also did with that, they first broke through this really, really thick ice, allowing that process to start at all.
Once they were there, yes, they had a lot of other things going for it. Because not only did the fiscal and political decentralization allow for that dynamism to happen, but it also created zones that comply, so to speak, to a large extent with the knowledge and the incentive problem.
It’s when you see zones, you can ask that first-level question. Do they solve the knowledge-incentive problem? Only then can you ask the harder questions. Have they actually solved other problems? I definitely do think, I mean, when you’re out and describing what you can learn from the Chinese case, you can definitely, easy – I mean, you know how to do that. You could definitely say, in what way is this solving the knowledge problem much better than other models that you might be considering? How is it solving the incentive problem? The size of the zones, definitely a factor there.
Then if you’re looking at a case of special economic zones, I would say that there’s the middle-level of difficulty here, which is, is it beneficial in the political economy context? That there, that is the asking of the question of, what would have happened if it didn’t have the zones? The zones can be beneficial compared to say, before you start the zones. Then the question is well, what would you have done instead? If otherwise you would have liberalized, I would say they’re actually not beneficial in the political narrative that you might have.
I’m presenting three levels, if that makes sense. The lowest one is knowledge and incentive problems. The second one is the political context problem. What would you have done otherwise? The third one is more like, are you at your best? Are the zones solving a huge problem? Which I think was the case in China.
Mark: Cool. Let me ask, because the knowledge and incentive problem, I’m somewhat sympathetic to them. I went to George Mason, but I actually think George Mason tends to overstate them a little bit. How do you think about the knowledge and incentive problem within the zone or charter city itself?
There will be a city government and they will not have the same access to prices. I mean, it’s a little bit closer to the people than the national government. At the same time, it also faces the knowledge and incentive problem.
Our operating assumption is that, with the right starting conditions, you can mitigate a lot of those problems. They will still exist, but they will not be nearly as present and not really be a major factor in the decision-making, once you mitigate them with the right starting conditions.
Lotta: I talked to a person who has a knowledge problem today. My boss has a knowledge problem. He doesn’t know what I’m doing right now. In any organization, you have a knowledge problem. The knowledge and incentive problem of both, they give you a statement of, there’s a cost. They don’t talk about what the benefit is, but it’s a cost that you shouldn’t ignore. Often, the benefit will be the same or better if you can solve the knowledge and the incentive problem. That’s why we want the private development, rather than government doing it. Usually, that’s a better solution.
I think of a charter city as a conglomerate, a big firm. The incentive problem has to be addressed. It can’t be that you’re somehow better off by bribing people or something like that. If it works, such that you can only be successful leading this charter city if you actually produce wealth in the charter city, you’ve got to have insight to do things right.
Then, the harder question, as you asked, is the knowledge problem. Can you do industrial policy? Can you plan anything? Yeah, companies plan things. If you want to make things optimized welfare in this space, you have the incentive to delegate when it’s appropriate. That’s what you do usually in a company. You create different sections of a company, doing things that should be done in a decentralized way, for a specific process.
Some decisions are made from the top and that’s going to be the same here. I don’t know if you would come across issues, where the company question would not apply to charter city question. Maybe I have a too simple of a model, but that’s the way I’m thinking about it.
Mark: No, I think that’s right. Our model is where the real estate developer has a heavy involvement with the city government. The Coasean point being that there always are these transaction costs that conglomerates, or companies, or firms, or whatever have overcome, but they continue to exist.
Depending on, some Austrians will probably bristle at this, some George Mason people, but you can probably fit, at least some of Hayek’s argument within the general Coasean framework of understanding how information moves within organizations. Let’s actually take a little bit of a step back. You finished your PhD at George Mason, like five, six years ago. We’re getting old.
Lotta: Five years ago.
Mark: Five years ago.
Lotta: Oh, my God.
Mark: Then you published your book what, three years ago or so? Yeah, but you’ve been spending most of time working in finance in Chicago. You have this insider and outsider view of how the charter city space has evolved. I want to get your perspective. How does it feel now versus several years ago? What do you think the changes are? What has been the experience of watching this space grow from the outside?
Lotta: Well, right now it’s a very interesting period with COVID and how that’s changing the world for sure. I’m actually, honestly impressed to see that there are great initiatives there that, I don’t know if we were unaware and they disappeared, but I really feel it’s our generation that got a lot of things going. Of course, we hope this is just a really small seed that’s going to really multiply.
I mean, everything that you’re seeing going on right now. We did have the attempt that was Honduras of Paul Romer, when we were still in school. Of course, there are always government initiatives that you hear about that talk to themselves as, “Oh, we’re a smart city, plus some version of something else.”
Yeah, I think that a lot of things have happened. I mean, of course I’m connected with lots of you. Yeah, I think that the ideas that are being spread out there, I think that’s great. I think it’s really important for us to make sure that people are studying today, hear about these ideas and therefore, decide to study. If they’re doing a PhD, do your PhD in this field because that’s when you really get a chance. I mean, PhD that was just a long vacation, where you can think about something really focused for a while.
When else are you going to have that time? People get out of school if they haven’t thought about something this conceptual and deep, you tend to go into more mundane tracks in my world. Having met a lot of people in finance, of course. That’s where I’m thinking like, I’m optimistic, but I’m thinking a lot of the energy is going to come from people who are way younger than we are. We’re already old now, and who are going to get the ideas when they’re still studying and have time to read and think hard about, because it’s so many conceptual ideas embedded in this that you’d hope, when you want your core people that you’re going to work with– I mean, you can hire other people who can just do their work, but when you want your core, you want them to understand and really pursue the ideas for what they are and the vision is.
Mark: This is one of the things that we’ve been trying to balance and juggle. Actually, if people come up to me and ask like, how they want to get involved, I will not tell, I think, anybody to go get a PhD. If you just think about it, okay, a PhD will take about five years. In five years, the space is going to be vastly, vastly different. If you really want to get involved, there’s a lot that can be done now that will probably increase lifetime earnings that will, in my opinion, at least, probably be more entertaining than my PhD was.
One of the things that I think we’re, I wouldn’t say struggling with, but trying to juggle and balance is this idea of how do you effectively communicate these deep, conceptual ideas to people while also having this very practical understanding of what needs to be done and what actions to be taken? In one sense, I think we’re trying to build on this school of thought that’s still relatively new, that’s still relatively nascent, to get this very large, coherent understanding.
On the other hand, we’re also trying to really have a very practical focus, engage in these projects on the ground, because ultimately, this is an action-oriented space. We do need academics, but I’m passionate about this in particular, because I think it has this real-world application. Balancing these two things I’ve seen as important, and I’m not sure we’re getting that balance exactly, but I think we’re doing okay at it.
Lotta: Yeah. I feel like you’re saying that if somebody’s doing a PhD, it’s too late already. I agree. I mean, it’s a matter of before you either do that, or get into whatever you’re trying to run to in your career. That’s more like, since everybody goes to college in this country, there’ll be college students, or people thinking about college even. Yeah, just getting people to think about the ideas when they have the opportunity and then getting excited or being in your space. Then you’ll know better in terms of how people find you easily.
I think that media like this, podcasts, great. Very good initiative. Blogs, but people have so much to read already. To some extent, blogs are good. Yeah.
Mark: Yeah, one of the things that I think we’ve struggled a little bit with is the distribution network. We’re currently hiring a head of communications, who we hope can help spread this message more effectively. We see it as a multiple tier process in terms of, one, engaging the young people, creating this strong talent pool available for charter cities, which is important in several dimensions. Just because one, you want to get general interest in the topic.
Then two, also as we’re thinking about charter city administration, there needs to be talented administrator for charter cities. If you’re building a charter city in Nigeria for example, you don’t want to hire people from the Nigerian government, because that’s the system that’s not working super effectively now. You don’t want them to bring those bad norms. You want to create this pocket of effectiveness, which requires new training mechanisms, new cultural mechanisms to ensure that you have this really effective governing structure.
Then in addition, what we also want to do is we see charter cities as an idea that really fits in with a lot of topics that people are discussing right now. From global warming, like, urban areas tend to be less carbon intensive than rural areas. If you design urban areas correctly, they’re even less carbon intensive than otherwise, to things like migration, to things like Chinese and American engagement on the world stage. Charter cities really address a lot of pressing topics today, and the other thing in addition to trying to develop a body of knowledge that can appeal to the next generation.
We’re also trying to engage the current generation of leaders in these different areas to say, “Hey, you care about X topic. Charter cities can help you address X topic, so let’s talk about what the engagement might look like and figure out how we might collaborate to help address X topic, with charter cities being part of that discussion.”
Lotta: Yeah. I mean, I experienced that when I started talking about special economic zones, which is way less cool than what you’re doing. People who don’t know anything about it, you can explain it in 30 seconds and they can ask the best questions, because it’s exciting, you get the concept.
It’s like, of course, you want a private city that it’s run in a better way. Of course, we want democracy to work better. Of course, I want all that. It’s almost from whatever part of what you’re pursuing, you can be a part of it. I can’t imagine that you would lack in opportunities, except COVID of course, but to participate in any event in any of the topics that you just said.
Mark: You’d be surprised.
Lotta: Oh, really? I would imagine that if you say like, “Oh. Well, you want somebody, maybe one session in your conference, or your seminar thing that you’re putting up here to talk about a different way to think about it and a different solution. It might be interesting. Have you heard about charter cities?”
Mark: What we’ve noticed is– my operating assumption was similar to that when I started the Charter Cities Institute that, right, we’ll have our foot in all of these different pies and because this is an interesting topic, we’ll get engagement from them. What we’ve realized is that people don’t really know how to place us. Because we’re not fully enmeshed in any single system, we’ve been ignored by a lot of these. That is changing over the last few months, it’s been changing. Now we have somebody doing partnerships, so we’re now being a little bit more aggressive in terms of our engagement with some of these other groups.
I expect it to continue to change. It’s an ongoing conversation and one that I was a little bit surprised in terms of coming forward with that proposal. Part of it was probably just because we were a young organization. People in some social networks are a little bit less trusting of younger organizations, because I was a little bit unpolished. I’m still a little bit unpolished, and so there’s a little bit of, “Hey, you’re young to be running an organization” or like, “what is this actually?”
We’re getting there. We’re getting that broader engagement, but it’s not quite there yet in terms of I think, all the spaces that charter cities could be a part of the discussion with.
Lotta: Part of it must be just to get the concept in people’s ears, or for you to just go on all kinds of podcasts and just talk about it, like, something that not going to attract somebody directly, sell something, but it’s like, more and more people just hear the words and heard about it. Then they start googling and it’s like, “Oh, what’s the organization that does this anyway?”
Mark: Yeah. That’s what we’re beginning to see, the repeated discussion, the repeat iteration has people paying more attention and becoming more willing to engage us. I think we’re basically in a charter cities moment right now.
Over the next few years that we will really see that engagement skyrocket and we’ll really see that level of interest skyrocket, just because it is a topic that really affects a lot of these global issues that we’re facing today.
Lotta: It’s interesting, me coming from the special economic zone world. I certainly believe that there’s going to be a case for more special jurisdictions in the world. I don’t see charter cities out-competing special economic zones, because they’re so different. I rather think that this is an opportunity to reform some of the old, inefficient special economic zones models as well, if the charter city becomes a concept that people can learn from.
Mark: Cool. There’s a lot of space for different models. I think there are a lot of successful special economic zones out there and charter cities are somewhat different. Most special economic zones don’t have residential areas. They tend to be a little bit more industry specific. The charter cities and special economic zones can complement one another.
Our approach is largely incremental. It might be difficult to bridge too far to get a full charter city initially, but to show that taking steps towards a charter city model leads to these better outcomes can help build support and momentum and change the conversation.
Lotta: I don’t know how much effect it’s going to have, but we’re living in a pandemic now. Pandemics tend to last a few years and people are really revising where they want to live, what their lifestyle is.
I suspect you’re going to have a lot of mobility. I mean, even just within countries, like people want to live more in the suburbs and not in the cities, or whatever they want to do, find more different ways of governance. You don’t need to be so close to your office anymore. More people are going to work from home. I don’t know. I’m thinking, it creates also a moment of mobility that opens opportunities for new jurisdictions.
Mark: We’ve definitely seen an increase in conversation. We’ve also seen a lot more projects start reaching out to us. I’m a little bit skeptical of that point with this increased mobility. I think it will lead to a short-term increase. There’s definitely a lot more conversation about intentional communities, about co-living spaces, moving to more rural areas. I suspect this will not be sustained basically for two reasons; one, if you look historically, cities have been through a lot of, I don’t know, pandemics, diseases, whatever, and people still like cities.
Then second, I think there’s a demographic piece to this. Millennials are a much larger percentage of the population than gen X, or gen Z. Millennials are right now reaching, mid-20s to mid-30s, even I think late 30s. Because millennials are such a much larger percentage of the population, as people enter their later stages and lives, they’re a little bit more likely to settle down. They’re a little bit less risk-averse. They’re less likely to travel.
We’re going to see millennials, as they start families, as they move to the suburbs, as they do things like this, that’s going to be a different dynamic. Gen Z, even if Gen Z, a higher percentage of their population wants to live in this remote work lifestyle, because the absolute numbers of Gen Z is less than millennials, even if the relative number increases of Gen Zers doing that, the absolute number might decrease. I suspect that this intentional community trend will be a little bit short-lived and people won’t be as concerned thinking about it in five years as they are today.
Lotta: Could it be that people move out from the cities, because they don’t want to be around all these virus? Then they start coming back. When they want to come back, they’re like, “Hmm. Do we need to move to the safe city? Or are we going to look for other new cities?”
Mark: That’s possible.
Lotta: Politics probably. Something.
Mark: Hard to know. Are you thinking about that?
Mark: Chicago is not as attractive as it used to be?
Lotta: We’re dull right now.
Mark: Cool. Well, I think that’s about our show. Thanks for coming on today, Lotta.
Lotta: Thank you so much for having me. Great to talk to you.
Mark: Thank you for listening to The Charter Cities Podcast. For more information about this episode and our guest, to subscribe to the show, or to connect with the Charter Cities Institute, please visit chartercitiesinstitute.org. Follow us on social media @CCIdotCity on Twitter and Charter Cities Institute on Facebook.
I’m your host, Mark Lutter and thank you for listening to The Charter Cities Podcast.
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