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Tuesday, May 1, 2007

Adam Smith in China

The Momentum for Market Liberalization in China is Strong

James Dorn is a China specialist at the Cato Institute and professor of economics at Towson University in Maryland. A shorter version of this article first appeared in the Times of India, January 24, 2007.

China’s transition from plan to market since 1978 has not only increased prosperity but also has led to a new way of thinking. In a 2005 poll covering 20 countries, GlobeScan found that China had the highest proportion of respondents (74 percent) who agree that the “free market economy is the best system on which to base the future of the world.” That outcome is remarkable given that only a short time ago Beijing embraced a state-led development model.

The same poll found that U.S. citizens have strong support for the free market (71 percent) while Russia, which has a long anti-capitalist history, still has rather weak support (43 percent favored the market), and France, with its long attachment to socialism, has even less support with only 36 percent saying they favor a free market.

The significant change in the Chinese people’s attitude toward economic liberalism is further illustrated in the Chicago Council on Global Affairs’ 2006 multination survey of public opinion. Eighty-seven percent of those surveyed in China thought that “globalization, especially the increasing connections of their country’s economy with others around the world, is mostly good for their country.” That result compares with 60 percent in the United States and 54 percent in India.

It is not surprising that the Chinese people would embrace globalization as it has opened China to the outside world, brought about rapid economic and social change, and helped lift millions out of absolute poverty. In 1978, only 12 large state-owned enterprises (SOEs) had the right to engage in foreign trade. Today virtually any firm is free to enter the import-export business. China has become the world’s third largest trading nation and is the leading destination for foreign direct investment. Those regions that have experienced the greatest amount of economic freedom have also grown the most and have the highest living standards. Guangdong, Zhejiang, and Fujian are all heavily “marketized” (SOEs account for only a small fraction of output) and have growth rates far above the national average.

In widening the range of opportunities open to people, globalization has increased personal freedom and put pressure on the Chinese Communist Party (CCP) and National People’s Congress to pass a Property Law last March. It recognizes the importance of the private sector and better protects property rights—all with a positive impact on civil society.

People are free to own their own homes, operate their own businesses, and seek work in the private sector. Those and other economic freedoms would have been impossible under central planning and autarky. One can now read a leading business magazine like Caijing and see a glossy photo of the Statue of Liberty on the same page as an advertisement for private condominiums in Beijing. F. A. Hayek’s Road to Serfdom and the Cato Institute’s Toward Liberty can be found in Beijing bookstores. High-school students in Shanghai can now open their new history textbooks and find much discussion of globalization and economic reform but only a single reference to Mao.

Most surprising, one can travel to the Southwestern University of Finance and Economics in Chengdu and see a life-size statue of Adam Smith, who in 1776 wrote in The Wealth of Nations: When “all systems either of preference or of restraint” are abolished, “the obvious and simple system of natural liberty establishes itself of its own accord.”

Spontaneous order, or economic harmony, arises out of voluntary exchange based on what Smith called the “laws of justice.” The role of market prices and profits is to coordinate the myriad individual plans in the pursuit of happiness.

Smith’s principle of spontaneous order—or freedom under the law—is similar to Lao Tzu’s principle of nonintervention (wu wei). Long before the Wealth of Nations was written, Lao Tzu argued that when the ruler takes “no action . . . the people themselves become prosperous.” Today China’s President Hu Jintao is promoting the idea of a “harmonious society” and “peaceful development.” In doing so, he should embrace the ideas of Lao Tzu and Adam Smith, and realize that limited government and the rule of law are essential for peace and harmony.

The problem is that the CCP has no desire to let go of its monopoly on power. Creating “free private markets,” as the late Milton Friedman recommended to General Secretary Zhao Ziyang when they met in 1989, would require widespread private property rights and further undermine the CCP’s influence. That is why China’s leaders continue to favor market socialism rather than market liberalism.

Nevertheless, the momentum for market liberalization is strong, especially since China joined the World Trade Organization in December 2001. Trade liberalization has been good for China and good for the global economy. Even though millions of Chinese workers have been dislocated, the Chicago Council survey found that 65 percent of those polled in China believe that “international trade is good for the job security of workers.” In contrast, only 30 percent of Americans surveyed thought free international trade benefited workers.

Of course, the goal of trade is not to protect jobs but to create wealth—and global wealth is much greater today than it was two or three decades ago. Trade liberalization, the information revolution, and financial integration have combined with pro-market institutional change to make China’s future bright. Trade is not a zero-sum game: the richer China becomes, the more prosperous the global economy. Protectionism would destroy the market forces that have helped lift millions out of poverty, embolden hardliners, and politicize economic life. Both economic and personal freedom would suffer.

One lesson from China’s transition from central planning to a market-oriented system is that poverty is best addressed by institutional change rather than foreign aid and government intervention. Several decades ago most of the world’s poor were concentrated in Asia, not Africa. The reverse is true today. Foreign aid has not improved the plight of the poor.

Likewise, increasing the minimum wage is not a panacea. Politicians promise a higher wage but do nothing to address the underlying causes of poverty. Rather, if the legal minimum wage is above the prevailing market wage for unskilled workers, employers will cut back on hours, reduce benefits, and switch to labor-saving methods of production.

Hong Kong has no minimum wage yet is prosperous. China has no national minimum wage and lets the market guide local minimum wages so that they do not interfere with economic growth and employment. In Shenzhen, one of the most marketized cities in China, the minimum wage was increased last year to 810 yuan per month (about $105). Many companies already pay more than the minimum, so the higher minimum wage is unlikely to interfere with job opportunities. Indeed, there is a labor shortage, so market wages will be forced up by competition. As one local labor official said, “We are adapting to the market through the pay raise, rather than interfering with the market.”

Entrepreneurship Everywhere

The spirit of entrepreneurship is evident everywhere in China. One of the most popular TV game shows is “Win in China,” a contest in which the person with the best business plan is awarded venture capital financing of $1.2 million and gets to retain 20 percent of the equity. The first show in 2006 attracted 120,000 entrants. The host of the show, Anna Wang Lifen, launched the program because she sees entrepreneurs as “the heroes of our peaceful times.”

Although China has made substantial progress on its march toward the market, much remains to be done. Free markets require widespread private property rights, a transparent and just legal system, and the free flow of information. Moreover, if China is to develop world-class capital markets, Beijing must make the yuan fully convertible and allow capital freedom.

The right to freely buy and sell currencies and assets is an important element of personal freedom. In his “Memorandum to General Secretary Zhao Ziyang,” Friedman listed what he considered the fundamental lessons from studying the process of development. The first lesson, which he thought applied to China as well as India, is that the government should “end exchange control, establish a free market in foreign exchange, and permit the exchange rate to be determined by the market.” Without such reforms, he thought, corruption would continue. Although Hong Kong does not have a freely floating exchange rate (it has a currency board that fixes the Hong Kong dollar to the U.S. dollar), there are no capital or exchange controls. The high degree of capital freedom has enabled Hong Kongto become a leading financial center.

China is moving gradually toward a more flexible exchange-rate regime and slowly relaxing capital controls. That process will take time, but it appears China’s leaders support the long-term goal of a fully convertible currency. Ending capital and exchange controls would give the Chinese people greater investment options and increase efficiency. But, again, such reforms would threaten the CCP’s power.

Opening the CCP to capitalists is not sufficient. The Party’s monopoly on power has to be contested at some point. Nor is it sufficient to amend the PRC Constitution to better protect private property when there is no independent judiciary to enforce contracts. If China’s future is to rest with the free market, there must be political as well as economic liberalization. Ultimately a free market cannot exist without a free people. The real challenge for Beijing will be to institute a rule of law that protects persons and property against the state. The people’s preferences will then rule rather than the Party’s. China’s leaders would do well to follow the path of Lao Tzu and Adam Smith by adhering to Hong Kong’s model of “Big Market, Small Government.”

  • James A. Dorn is vice president for monetary studies, editor of the Cato Journal, senior fellow, and director of Cato’s annual monetary conference.