Distortions, Growth Catch-up, and Sustainable Growth

A distortion is a departure from the allocation of economic resources from the state in which each agent maximizes his/her own welfare. Distortions can be divided into endogenous distortion(i.e. market imperfections) and policy-imposed distortion. The relationship between distortion and development is complex, thus favorable distortion would only be possible under certain conditions, where, as argued in this paper, four crucial mechanisms may play roles — advantage of backwardness, second-best principle, coordination failure and political economy perspective. Empirically, both international experience and evidence from China suggest that distortions have a positive effect on total factor productivity(TFP) in the early stages of development, but with increasing income levels this role gradually diminishes. Especially in the phases of middle and high income, the negative effects of distortions are significant and become an important factor leading to the middle-income trap. Therefore, reducing and correcting distortions is the key to achieving sustainable growth. Regarding China, it is necessary to eliminate the distortions in a clear way and let the market play the decisive role in resource allocation. Otherwise, in the name of "growth catch-up," the policy-imposed distortion will occur frequently, and the direction of market-oriented reform will become blurred and swing. Mitigating unfavorable distortions is largely a process of exploring the favorable borderline of government and market, which constitutes a major challenge for all economies.